Delta is arguably the most important and most often discussed option risk metric. Delta can tell us a lot about our positions and portfolio. There are four main uses for delta we all should understand.
Deltas communicate the amount an option’s price will change when its underlying stock’s price changes $1.00, and are expressed as either positive or negative numbers. Positive delta has a bullish directional bias while negative delta expresses a bearish bias. If we buy an option with a delta of .25 that means for every $1 the stock moves, the option will move $0.25. The inverse is also true. If the stock drops $1, the option will drop $0.25.
Another way we use delta is to understand the equivalent number of shares an option represents. That option with a .25 delta is equivalent to owning 25 shares of the underlying. Therefore, if we want to use an option as a stock equivalent, we can do so by looking at delta. If we are long 75 shares of stock and want to increase that position to 100 shares, we might look to sell a put with .25 deltas or buy a call with .25 deltas.
Options needed to delta hedge a stock position
It makes sense if delta expresses share equivalency that it also works for hedging. One share of stock has one delta. A position of long 75 shares of a stock can be hedged against a drop in the stock’s price by purchasing a put with a .75 delta. Combining stock with option delta allows us to create hedges against individual positions and portfolios as a whole.
Probabilities of market move
The fourth way we use delta is as a measure of probability. Delta is an approximation of the probability an option will be in the money at expiration. An option with a .25 delta has a 25% chance of being in the money at expiration. If we sell an option with a .25 delta, that means we’re looking at a 75% chance that this option will not be in the money at expiration.
Delta is a dynamic number when it comes to understanding our market exposure. It allows us to view positions in terms of direction, shares of stock, hedging and probabilities. We spend a lot of time discussing delta because of the many things it communicates about our trades.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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