Why We Love Delta. You Should Too.
Delta is the Greek Superhero of Options Trading
Learning the Lingo
One of the barriers of learning and improving your options trading skills is the Lingo. The language is filled with cryptic, ancient, vernacular terms, and acronyms (OTM, DTE, BTO, STC… )
It may lead you to believe that jargon is there as a barrier of entry [it is]. That it intentionally exists to protect the territory of some large financial institution [You may think so, I couldn’t possibly comment…]. And that only a few in few places can master.[really?]
But if you enjoy learning, if you like to control your destiny. If you do not buy into the credo that you should place your money blindly into the first passive vehicle available. Then learning is the way to transition from cluelessness — and innocent victim floating on the waves; and whatever happens, happens — to at the very least alter the probabilities of the outcome on your investments.
So, IMHO lingo must be learned, dominated, mastered, there is no way around it. Lingo allows you to convey complex concepts in a precise, concentrated way. They are very powerful. They are the superheroes of trading.
Welcome the greek and other superheroes
All around greeks are very kind and proud people. Kind and generous. Not only ancient Greeks gave us great inventions, such as democracy, philosophy, and gyros [maybe not], but also the Greek Alphabet. So here we have them. I introduce you to The Greeks:
- Delta is number one. Delta is direction, probabilities and many other useful things
- Vega, how volatile this is compared to something else
- Theta: Theta is time decay. How do you profit from getting older?
- Gama: how fast are you going to get directionally exposed, how fast things are changing.
The Multifaceted Delta
But this article is about Delta. Delta is very powerful and multifaceted, like your favorite superhero. Delta has an all-around personality. So if you have tolerance for just one greek, I would encourage you to adopt Delta.
- Delta is a derivative of price
- Delta is Direction (position & portfolio)
- Is Moneyness
- Is the Probability of profits
- Delta is normalized — The Esperanto of derivatives
Delta is a derivative of price: Delta shows you how the changes in the underlying prices affect the price of the option contract. Technically, the value of the option’s delta is the first derivative of the value of the option with respect to the underlying security’s price. (1)
For example, assume an investor is long a call option with a delta of 0.30 (we refer to this as a 30 Delta Call, without the decimal). Therefore, if the underlying stock increases by $1, the option’s price would theoretically increase by 30 cents, and the opposite is true as well.
Delta is Direction: If a position is Delta positive, it will benefit from the increase in the price of the underlying. You are “Long Delta”. If your position’s Delta is negative, you want the price to go down.
You can calculate the total Delta of your portfolio. The total Delta will tell you how exposed are you to a market change in direction. Again a portfolio that is short delta, will benefit from prices going down.
Delta is moneyness. Delta is commonly used by traders as a measure of (percent) moneyness. Delta values are not identical to the actual percent moneyness, but for practical cases, these are quite close. For example, a contract with 79 Delta is said to be in the money, 50 Delta is said to be at the money and 16 is out of the money (OTM). Here for a more complete explanation.
Delta is normalized — Esperanto of derivatives. Delta is universal. Its value is independent of the equity or its nominal value. You can find a 16 Delta Put in any stock — no matter how cheap or expensive the stock is — and you can also find that same contract that was at 16 deltas 5 years ago. Delta allows you to compare trade strategies across time and asset classes. The second part of this article will cover this topic.
Delta is Probability of profits: Delta can also be used as a Proxy (2) of probability. Delta indicates approximate probabilities of a contract ending in the money at expiration. So a Short PUT contract at 16 Delta, has an expected probability of 16% of being at the money on expiration. (or 84% expected probability of profit)
This last feature is one of the most interesting and useful characteristics of Delta.
Where Do These Probabilities Come From?
One of the major schools of mathematical probability makes betting the fundamental definition of probability. Betting is expressing an opinion with your wallet. It is a principled measure of the strength of one’s belief. In our case, these opinions are reflected in the prices of the options. What the market is willing to pay for each contract. Thousands of bets, in real time. This makes the pricing of options very efficient. Particularly on the most active and liquid names.
The probabilities are thus derived directly from these prices. Crowdsourced expected probability. Now instead of saying it is likely that this stock will hit $120 by next month, you can say: the market assigns a 30% chance to the price getting to$120.
Imagine this scenario. You buy Apple stock, with the expectation that it will get to $225 in 4 weeks. You may think that, but I couldn’t possibly comment. What I can do, is look at the Deltas, and see that the market sees a mere 10% chance of that happening. If you are so sure, I will certainly take the other side.
Suddenly you have an efficient way to allocate money. Especially when you do at the very least have the benefit of the crowd wisdom as reflected in these prices, and the probabilities that arise from them. Expected probabilities that translate into Deltas. Deltas that are easy to read, follow and that you can ignore at your own peril.
Examples on why use Delta to examine dissimilar options strategies
Visit eDeltaPro Option Engine Backtesting and test your strategy at different Deltas
(1) Investopedia — Delta
(2) Remember, these are “rule of the thumb” approximate probabilities. But for everyday trading — and backtesting — they are very useful.