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Guide To Options (Part 3)

Understand options today.


In our last article, we focused on payoff profiles and how they help you to understand your risk and reward when investing in options when you intend to hold them to expiry. However, what if you don’t want to hold them to expiry? How your P&L is determined can be estimated by what traders call the Greeks.

The Greeks are simply variables that the industry uses to estimate changes in option values under different scenarios. Put simply, they help to measure how your P&L changes according to various sources of risk. We will be focusing on the most relevant ones – starting with delta in this article.

Delta Is The Connection Between The Option Value and Stock Price

Delta is the answer to the simple question: If my stock goes up by $1, how much would my call option value go up by? The quick and dirty estimation uses delta to measure that change in option value. In this case, if the delta is 0.3, the call option value would go up by (0.30 x $1 = $0.30). Put options have negative delta, so if the stock went down by $1 and delta was -0.30, the put option value would go up by (-0.30 x $1 = $0.30).

Delta Is Not Constant

Another thing to note is that delta is not constant. This means that your option’s sensitivity to the underlying stock price changes according to where the current stock price is in relation to the option’s strike price. Across all options, delta moves from -1.0 to 1.0 as the option goes from deep out-of-the-money to deep in-the-money.

One way to better understand this is to think of delta as the probability of the option expiring in-the-money.

Hence, it is not a coincidence that when a stock is trading exactly at an option’s strike price, the delta will be 0.5, representing a 50% chance of either being out-of-the-money or in-the-money. If the stock price keeps going up, chance of the option expiring in-the-money increases until delta goes to a ceiling of 1.0. Therefore, the delta of deep in-the-money options tend to be 1.0, ie. Option value moves $1 when the stock price moves $1.

Without going into deep detail, how much delta changes is determined by another Greek called gamma. Gamma tends to be highest when the stock price is trading at-the-money, so option values tend to see their biggest changes when the stock price starts trading around that region.

Things To Note

As mentioned earlier, option value changes are determined by several factors, not just delta. Hence, delta is an estimation assuming all other factors remain the same, which is hardly true in real life. Delta is also significantly impacted by time and volatility, variables which will be covered in future articles.

Read Also: Finance Dummies Guide: Options (Part 2)

Read Also: Finance Dummies Guide: Options (Part 1)

 

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