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The Importance of Delta - Options Mastery Series Lesson 8

Filed Under Options Mastery Series 

#8 The Importance of Delta
Wouldn’t it be nice to know before entering a trade what your chances are of making a profit? If you look at several potential trades and one has a much better statistical probability than the other of finishing in-the-money, which one would you choose? For example, imagine the normal distribution curve with the current price at the median. If the strike price is the same as the current price, there is a 50% probability that at the time of expiration the stock will be in-the-money. That is, if at expiration the sock price is at or above the current price it will be in-the-money. If it is below the current price, it will be out-of-the money and worthless.
 
Now, if you have a strike price below the current price at the meridian (50% point) there is a greater probability that the current price will end up ITM. The current price would have to move to the left and the additional distance between the median and the lower strike price increases probability that the current price will end up ITM. Moreover, the more the strike price is below the current price, the greater the probability of finishing ITM. As a matter of fact, if the strike price is near the low end of the curve, the probability of finishing ITM is near 100%. Of course, the greater the amount of volatility in the stock, the wider the end-points of the curve.
 
                $30       $38 strike                $50                                     $70
insert fig8-1
                                 .94 prob of ITM    .5 probability of ITM           
 
Strikes to the right of the current price (median) would be probability of ending out-of-the-money (OTM). The width of the curve is representative of the stock volatility; therefore even though a strike may appear to be close to the current price that doesn’t necessarily represent a high probability as defined by Delta. Additionally, Delta has two other definitions besides probability of finishing ITM.
 
Delta also tells us how much the derivative option will move in relation to the underlying stock. For example, if the stock moves $1 and the option has a Delta of 50 (a contract is 100 shares with a delta of .5 each), the option will move 50 cents in the same direction as the stock. When an option is deep in-the-money, it very closely matches the movement of the underlying stock. A Delta of 90 means if the underlying moves $1, the option contract premium will move 90 cents. Many beginning option traders don’t understand this important relationship. They think that an out-of-the-money option is just another less expensive surrogate for the underlying stock. As you now under-stand, an option has to be pretty deep ITM to act as a correlated surrogate. The more in-the-money an option is, the higher the premium. As a matter of fact, buying ITM is more expensive but with a greater probability of being a profitable trade. OTM options do offer a higher ROI (return on investment) but with less statistical frequency.
 
Finally, Delta provides an important input for hedging risk but this topic will be a subject for another article. Stay tuned.
 
For a complete education on the subject of stock options, contact Options University at www.optionsuniversity.com
 

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