Understanding options just got a lot easier: How you can use the ³delta² to become a master trader

by Bryan Bottarelli

On the options trading floor, you learn the meaning of “sink or swim.” This is the mentality on the Chicago Board Options Exchange (CBOE).

They throw you in with the sharks, and you either fight for your life, or you become the chum. You have to learn fast. When I was trading options on the CBOE, one of the first things that was drilled into my head was understanding a number called “delta.”

Using any tracking service, you can access an option’s delta. It will always range between 100 and -100. Calls have positive delta. Puts have negative delta. The delta represents the dollar value change of your option as the underlying stock moves up or down US$1.00

If a stock option with a 50 delta goes up US$1.00, then your call options contract will go up US$0.50. On the other hand, if a stock option with a 50 delta goes down US$1.00, then your put options contract will go up US$0.50.

Say Amgen is trading for US$70 a share. You buy a September 70 Call. This option gives you the right to buy 100 shares of Amgen anytime before the September expiration for US$70 a share. You pay US$7 a share for this option.

This is what is called an “at the money” option. The price of Amgen stock is the same as your option’s strike price. Look up the delta on this option and you’ll find that it has a delta of 50. So, the question remains: if Amgen goes up to US$80 a share, and I have the right to buy 100 shares for US$70, how much will the option be worth? The answer lies in the delta.

Since this is a call, every US$1 move up in Amgen stock will move your Amgen call up US$0.50. For example, if Amgen ticks up to US$71 a share, your option to buy 100 shares for US$70 will be worth US$7.50 (remember, you paid US$7 for the option).

So, if you think Amgen will trade at US$80 a share before September, your US$7 option contract will go from your buy price of US$7 to US$12 (a US$10 rise x US$0.50). Thus a 14% gain in Amgen stock equates to a 71% gain in your Amgen option.

Get it? OK, try this example: eBay is trading for US$60 a share. You pay US$5 for the right to buy eBay for US$65 a share by September expiration. (Did you notice you are now buying an “out of the money” option? In other words, your strike price is higher than the actual eBay stock.) Since you are buying the right to buy eBay for US$65 a share, even though it’s trading for only US$60 a share, your delta is less. The delta of this option is 35.

Should eBay move up to US$65 a share, how much would your option be worth?

Let’s calculate it: a US$5 move x US$0.35 = US$1.75. Add that to your US$5 buy price, and you get US$6.75. And there you have it. Once again, an 8% gain in a stock gives you a 35% gain in the stock option. And best of all, you know ahead of time how your option moves compared to how the stock moves.

But that’s just the first definition of delta.

Delta gives you the percent chance that your option will expire “in the money”

On face value, simply looking at an option’s delta will tell you point blank how risky it is. And it does that by giving you a percent chance that your option will expire in the money, or, in other words, above the price of your strike.

Here’s another example. HGSI is trading for US$50 a share. You buy a September 50 Put. This would give you the right to sell 100 shares for US$50 a share. The delta on this option is 50. So, you have a 50/50 chance of this option expiring in the money.

On the flipside, you buy a September 40 Put. This would give you the right to sell 100 shares for US$40 a share. Since this option is out of the money, it has a lower delta—or a lower chance of expiring in the money. In this case, the delta is 35.

So you know ahead of time that you have a 35% chance of this option expiring in the money. Knowing the percent chance of an option expiring in the money will help you make better sense of the options you pick.

For traders only—the delta gives you a “hedge rate”

This definition will help you if you’re looking to hedge your options positions with stock. For example, say you’re really bearish on Microsoft, and you buy 20 September 50 puts. But, to be safe, you want to protect yourself should the stock go up, so you want to buy some shares of the underlying stock, too. The only question is: how many shares do you buy?

Once again, look to the delta.

Let’s assume the delta of the September 50 Put is 45. You bought 20 contracts, which give you the right to control 2,000 shares of stock (20 contracts x 100 shares of stock per contract). You don’t want all your gains to be eaten up as Microsoft goes down, so you need to hedge with the appropriate amount of Microsoft stock. Here’s what you do:

Take the total number of shares you control (in this case 2,000) and multiply it by the delta (.45). What you get is 900—and that’s the number of Microsoft shares you want to buy to hedge against your put position.

There you have the three ways you can evaluate options investments using one simple number.

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