There are various factors that affect the price of an option known as Option Greeks. These are the tools that help an investor know the most suitable options to trade and the best time to trade them. These Option Greeks include Gamma, Delta, Theta, Vega, and Rho.
Option delta, also known as the hedge ratio, is used to compare the change in an underlying asset with the change in the option’s price. Delta values for calls are from 0 to 1, while the values for puts are from 9 to -1.
In-the-money options have values closer to 1, whereas those out-of-the-money have values closer to 0.
How does delta affect the cost of an option/contract?
The delta value of a call option always ranges from 0 to 1 because an increase in the price of any underlying asset leads to an increase in the price of the call options.
However, delta values of put options range from 0 to -1 because as the value of an underlying asset such as a stock or a security increases, its put option decreases.
For example, if the put option has a delta value of -0.25, and subsequently, the value of a stock or a security increases by $1, the put option’s value will end up decreasing by $0.25.
Also, if a call option has a delta value of 0.50, and the stock goes up by $1, that means that the value of the call option will increase by $0.50.
The general rule of options is that the in-the-money options move more than the out-of-the-money options. This is because short-term options are more affected by price variables as compared to long-term options.
Whenever an option gets further in-the-money, its probability of staying there increases, leading to an increased option’s delta. However, when the options get further out-of-the-money, their chances of staying in-the-money end up decreasing. This lowers the option’s delta.
The delta ratio is often affected by the expiry date paradigm. Whenever the option is closer to the expiry date, it’ll likely stay at the current position, i.e., in or out of the money.
According to Tasty trade, it can be very difficult to trade directionally, so we often choose to keep our deltas neutral. This means that if there are big directional moves, our portfolio will be at less risk than if we were fully directional and wrong.
How do you calculate delta?
The formula for calculating option’s delta is:
Where;
- ∂ represents the first derivative
- V represents the theoretical value of the option’s price
- S represents the underlying asset’s price
The first derivative of the option and underlying asset prices is used because it shows the measure of the rate of change of the variable at that particular time.
The delta is always expressed as a decimal.
Conclusion
Delta ratios are useful in options trading because they help investors know the risk they have to bear by purchasing or selling certain stocks or securities.
