In options trading, Delta is an important assessment tool used to measure risk sensitivity. Delta is a risk metric that compares changes in a derivative’s underlying asset price to the change in the price of the derivative itself.
Essentially it measures the sensitivity of a derivative’s price to a change in the underlying asset. Using Delta as part of an options assessment can help investors make better trades.
Delta is one of “the Greeks,” a set of options trading tools denoted by Greek letters. Some traders might refer to the Greeks as risk sensitivities, risk measures,or hedge parameters. The Delta metric is the most commonly used Greek.
Recommended: A Beginner’s Guide to Options Trading
Option Delta Formula
Analysts calculate Delta using the following formula with theoretical pricing models:
Δ = ∂V / ∂S
• ∂ = the first derivative
• V = the option’s price (theoretical value)
• S = the underlying asset’s price
Some analysts may calculate Delta with the much more complex Black-Sholes model that incorporates additional factors. But traders generally don’t calculate the formula themselves, as trading software and exchanges do it automatically. Traders analyze these calculations to look for investment opportunities.
Option Delta Example
For each $1 that an underlying stock moves, an the equity derivative’s price changes by the Delta amount. Investors express the Delta sensitivity metric in basis points. For example, let’s say there is a long call option with a delta of 0.40. Investors would refer to this as “40 delta.” If the option’s underlying asset increased in price by $1.00, the option price would increase by $0.40.
However, the Delta amount is always changing, so the option price won’t always move by the same amount in relation to the underlying asset price. Various factors impact Delta, including asset volatility, asset price, and time until expiration.
If the price of the underlying asset increases, the Delta gets closer to 1.0 and a call option increases in value. Conversely, a put option becomes more valuable if the asset price goes lower than the strike price, and in this case Delta is negative.
How to Interpret Delta
Delta is a ratio that compares changes in the price of derivatives and their underlying assets. It uses theoretical price movements to track what will happen with changes in asset and option price. The direction of price movements will determine whether the ratio is positive or negative.
Bullish options strategies have a positive Delta, and bearish strategies have a negative Delta. It’s important to remember that unlike stocks, options buying and selling options does not indicate a bullish or bearish strategy. Sometimes buying a put option is a bearish strategy, and vice versa.
Recommended: Differences Between Options and Stocks
Traders use the Delta to gain an understanding of whether an option will expire in the money or not. The more an option is in the money, the further the Delta value will deviate from 0, towards either 1 or -1.
The more an option goes out of the money, the closer the Delta value gets to 0. Higher Delta means higher sensitivity. An option with a 0.9 Delta, for example, will change more if the underlying asset price changes than an option with a 0.10 Delta. If an option is at the money, the underlying asset price is the same as the strike price, so there is a 50% chance that the option will expire in the money or out of the money.
For call options, delta is positive if the derivative’s underlying asset increases in price. Delta’s value in points ranges from 0 to 1. When a call option is at the money the Delta is near 0.50, meaning it has an equal likelihood of increasing or decreasing before the expiration date.
For put options, if the underlying asset increases in price then delta is negative. Delta’s value in points ranges from 0 to -1. When a put option is at the money the Delta is near -0.50.
How Traders Use Delta
In addition to assessing option sensitivity, traders look to Delta as a probability that an option will end up in or out of the money. The more likely an option is to generate a profit, the less risky it is as an investment.
Every investor has their own risk tolerance, so some might be more willing to take on a risky investment if it has a greater potential reward. When considering Delta, traders recognize that the closer it is to 1 or -1 to greater exposure they have to the underlying asset.
If a long call has a Delta of 0.40, it essentially has a 40% chance of expiring in the money. So if a long call option has a strike price of $30, the owner has the right to buy the stock for $30 before the expiration date. There is a 40% chance that the stock’s price will increase to at least $30 before the option contract expires.
Traders also use Delta to put together options spread strategies.
Traders also use Delta to hedge against risk. One common options trading strategy, known as neutral Delta, is to hold several options with a collective Delta near 0.
The strategy reduces the risk of the overall portfolio of options. If the underlying asset price moves, it will have a smaller impact on the total portfolio of options than if a trader only held one or two options.
One example of this is a calendar spread strategy, in which traders use options with various expiration dates in order to get to Delta neutral.
With a Delta spread strategy, traders buy and sell various options to create a portfolio that offsets so the overall Delta is near zero. With this strategy the trader hopes to make a small profit off of some of the options in the portfolio.
Using Delta Along With the other Greeks
Delta measures an option’s directional exposure. It is just one of the Greek measurement tools that traders use to assess options. There are five Greeks that work together to give traders a comprehensive understanding of an option. The Greeks are:
• Delta (Δ): Measures the sensitivity between an option price and the price of the underlying security.
• Gamma (Γ): Measures the rate at which Delta is changing.
• Theta (θ): Measures the time decay of an option. Options become less valuable as the expiration date gets closer.
• Vega (υ): Measures how much implied volatility affects an option’s value. The more volatility there is the higher an option premium becomes.
• Rho (ρ): Measures an option’s sensitivity to changing interest rates.
Delta is a useful metric for traders evaluating options and can help investors determine their options strategy. Traders often combine it with other tools and ratios during technical analysis. However, you don’t need to trade options in order to get started investing.
A great way to begin investing is by opening an investment account on the SoFi Invest® app. While SoFi does not offer options trading, it does allow you to research, track, buy and sell stocks, ETFs, and crypto right from your phone.
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