Delta is a financial metric that measures how much the price of an options contract is expected to change for every one-unit change in the price of its underlying asset.
Understanding delta in options trading
Options traders use delta to calculate directional risk. For standard call options, delta ranges from 0 to 1. This means the option price increases as the underlying asset price rises. Put options have a delta ranging from -1 to 0, meaning the option price increases when the underlying asset price falls. The metric assumes all other pricing variables, such as time to expiration and implied volatility, remain constant.
The value of delta changes as the price of the underlying asset fluctuates. It approaches 1 for call options, or -1 for put options, as the contract moves deeper into the money. Options that are at the money typically have a delta near 0.50 or -0.50. This indicates the option premium will move approximately half a point for every one-point move in the underlying asset.
Fellow Elephants, you can also use delta to estimate the probability that an option will expire in the money. While it is not an exact probability calculation, a call option with a 0.20 delta is generally interpreted by the market as having roughly a 20 percent chance of finishing in the money. Institutional traders also use delta for hedging purposes. By buying or selling the underlying asset in proportion to the option delta, traders can create a delta-neutral portfolio that isolates the position from small directional price movements.
Example
Suppose an elephant investor buys a call option on shares of Savannah Logistics. The stock is currently trading at 50 per share, and the call option has a premium of 2 and a delta of 0.40. If the stock price increases by 1 to 51, the delta indicates that the option premium will increase by 0.40. The new price of the option contract will be 2.40, assuming implied volatility and time to expiration remain unchanged. If the stock price drops by 1 to 49, the option premium will decrease by 0.40, bringing the new price down to 1.60. As the stock continues to rise and the option moves further into the money, the delta will gradually increase toward 1.