Delta is a fundamental Greek we focus on at Good Kids Trading (GKT). If you want to make successful options trades understanding delta is crucial! Delta measures how an option price will move in relation to a one-dollar change in the underlying stock price. I like to think of delta in terms of MPH of a car. The higher the delta, the faster the option price moves as the underlying moves. But we use delta for more than just trading individual options, let me explain.
Decoding Delta: Essential Insights for Options Traders
For calls, the range of delta is from 0 to 1. A delta of 0.60 means that the option price will go up or down by 60 cents for each dollar that the underlying stock moves. On the other hand, for puts, delta ranges from -1 to 0. A delta of -0.532 means that the option price will increase by 53 cents if the underlying stock moves down by one dollar.
We can also use delta to indicate the probability of an option being in the money (ITM) at expiration. If we sell a put that has a Delta of 30, it indicates a 30% probability of the option expiring in the money.
As premium sellers, we want options to expire out of the money, so a lower Delta corresponds to a higher probability of success!
If you're thinking about selling a covered call and want to know the probability of the stock reaching the strike of your covered call you can check the delta of the call option.
Let's look at this example: If you wanted to sell a covered call on your Apple shares at 180,
you can see the delta is .25. This means there is a 75% chance this call will expire worthless. To be clear, we look at more than just delta when selling calls at GKT, but I want to illustrate how delta works. If you want to read more about covered calls checkout this blog I wrote with all my "secrets" delta is a very important factor I consider as well.
By adjusting the expiration date you can see how the probability changes. The call in the example above expires in 45 days. What happens if you choose a closer expiration date?
This covered call that expires in 10 days, as you can see the 175 strike is the closest to .25 delta. So the strike moved by $5. The premium collected also changed. Delta of options are impacted by many factors including days to expiration. The more time you have on an option the more time (Theta) and uncertainty (Volatility) is priced into the option.
GKT uses delta for our put sales as well! If you're interested in buying the dip on Apple and you want to know the probability of getting shares (based on delta) you can look for a strike in the -20 to -30 delta range. Meaning there is an 80-70% chance this option expires out of the money.
You can see that the 160 strike put has an 80% chance of expiring worthless, and the 165 strike put is closer to 70% in terms of expiring worthless. We do not just look at delta when selling puts, but it is part of our consideration! Read more about how I generate income using put sales.
Understanding Exposure to Market Movements
Delta can be used as a share equivalent to measure directional bias or exposure. A position with a Delta of 40 would behave like owning 40 shares of stock, even though the contract is for 100 shares. Keep in mind that shares never expire, and options always do! Conversely, a Delta of 80 would feel more like the full contract size and weight.
You can monitor your options delta to understand how your position compares to owning shares of stock.
Delta of your Entire Portfolio
At the portfolio level, Delta provides a broad market view of directional exposure. For example, if portfolio deltas were 200 and beta weighted to the SPY, it would suggest an equivalent of owning 200 shares of SPY in the overall portfolio.
This is a powerful way to determine how much you account will move up or down as SPY moves. We will write an entire article on portfolio hedging. In the mean time you can checkout our discord and you will see why I sometimes setup put spreads to hedge my delta when the market looks like it might pull back! I monitor my total delta's and I add put verticals (which have negative deltas) to help my account from moving as much. I'm looking to neutralize my deltas!
Navigating Returns with Delta in Options Trading
Delta's relationship with returns is a classic give-and-take dynamic. Selling options with higher Delta values, such as 45 (meaning close to the share price) over a 30 delta option, will generate higher returns. This is because options with higher Deltas have higher premiums. However, this higher return comes at the cost of a lower probability of profit and more risk that your option expires ITM. Deltas represent probabilities, and selling options with higher Deltas means accepting lower probabilities of profit.
You know I love to sell strangles, I wrote why I love strangles to reduce my cost basis now that we've discussed delta, you understand that selling a 20 delta covered call and a -20 delta short put has a better chance of expiring worthless, than a 30 delta covered call and a -30 delta short put. Of course selling a 20 delta strangle pays less premium, there is no free lunch in the stock market.
Mitigating Risk with Delta Management
The stock market is random and unpredictable, and as option traders, we have a number of advantages to mitigate risk. When it comes to Delta, the key to reducing risk is controlling your size.
Whether at the individual position level or the overall portfolio level, it is crucial you make sure your Delta is manageable. Understanding our directional exposure is essential in managing risk.
It's natural to have a bias and take positions based on hunches, it's important to remember that the market is unpredictable. Staying small and staying informed about Delta can help you control your risk in this uncertain market.
Understanding Delta allows us to assess the potential movement of option prices as stock prices change. Delta serves as an approximate probability gauge and a share equivalent to measure directional bias. When it comes to returns, Delta can help us determine the optimal options to sell. And in managing risk, controlling our Delta and understanding our directional exposure is key. By staying small and being equipped with the knowledge of Delta, we can make better decisions in the options market.
I hope you enjoyed this post and learned something new. If you did, please share it with your friends. And if you want to learn more and how to apply them in different market conditions, join our discord! Subscribe for our weekly newsletter. It's all free!
Happy Trading Good Kids!
Disclaimer: this is NOT financial advice. I’m basically just some dude on the internet who’s been trading a while, and I use the stock market as my primary source of income. None of this is financial advice it’s purely educational!
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