The option delta measure tells the option trader how fast the price of the option will change as the price of the underlying asset moves up or down.
An option's price can be influenced by a number of factors. These factors can either help or hurt traders, depending on the type of options positions they have established. To become a successful option trader, it is essential to understand what factors influence the price of an option, which requires learning about the so-called "Greeks" - a set of risk measures that indicate how exposed an option is to time-value decay, implied volatility and changes in the underlying price of the commodity.
The first "Greek" that most people learn about when they get involved in options is Delta. This important measure, the option delta measure, tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.
The four most commonly used "Greek" risk measures are delta, theta, vega and gamma.
Definition of Greeks
Greeks are dimensions of risk involved in taking a position in an option (or other derivative). Each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable. Various sophisticated hedging strategies are used to neutralize or decrease the effects of each variable of risk.
Therefore, the Definition of Option Delta is explained as the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative -- sometimes referred to as the "hedge ratio".
If you own a call option that carries a delta of 0.5, that means that if the stock goes up by $1.00, your option will increase in value by $.50 (if the stock falls by $1.00, your option will fall by a little less than $.50).
The useful way to think about the option delta measure is to consider its value to be the probability of that option finishing up (on expiration day) in the money. If you own a call option at a strike price of 60 and the underlying stock is selling at $60, you have an at-the-money option, and the delta option measure will likely be about 0.5. In other words, the market is saying that your option has a 50-50 chance of expiring in the money (i.e., the stock is above $60 so your option would have some intrinsic value).
If your option were at the 55 strike, it would have a much higher delta value because the likelihood of its finishing up in the money (i.e., higher than $55) would be much higher. The 55 call might have a delta of 0.8 or 0.9 (or if the option is about to expire, it will approach 1). With the stock at $60 and the strike at 55, the stock could fall by $4.99 or go up by any amount and it would end up being in the money, so the delta option value would be quite high.
On the other hand, if your call option were at the 65 strike while the stock was selling at $60, it would carry a much lower delta (maybe 0.1 if expiration is near, or 0.3 if there are a few months to go until expiration) because there would be a much lower likelihood of the stock going up $5 so that your option would expire in the money.
Of course, the amount of remaining life also has an effect on the delta value of an option. For in-the-money call options, the closer to expiration you are, the higher the delta option value. For out-of-the-money options, delta values are higher for further-out expirations. Most brokers show you the net delta value of your long and short options at all times (or the deltas of any options you are thinking of buying or selling).
An Example of the Option Delta Measure at Work!
Let’s assume you had bought the December call options for Apple (AAPL) which expire on December 16th. With the stock currently trading about $395, the Dec-11 395 call carries a delta of 0.5 (meaning the market is betting that there is a 50-50 chance of AAPL trading above $395 in two weeks, at expiration). We are also short a Dec-11 405 call which carries a delta of 0.3. The market figures that there is about a 30% chance that AAPL will be above $405 in two weeks. And the Dec-11 415 call has a delta of only 0.14, so the expectation is that 14% of the time, the stock might rally by $20 over those two weeks.
Three things to keep in mind with Delta Option Value:
1. Delta tends to increase as you get closer to expiration for near or at-the-money options.
2. Delta is not a constant, a fact related to gamma, which is a measure of the rate of change of delta given a move by the underlying.
3. Delta is subject to change given changes in implied volatility.
Finally, always remember that there is a risk of loss when trading futures and options -- trade only with risk capital.