One very important factor that many traders ask me about is how far in the money or how far out of the money they should go when buying an option.
In essence, the issue is Delta, which is the Greek term for the expected change in the option for every dollar fluctuation in the underlying stock.
Delta is not constant, it shifts like a moving target, as the price of the underlying asset moves higher as well as lower.
Assuming you are trading to the long side, if the Delta is positive 1.00, the option will move 100% or $1.00 with the underlying stock and if the Delta is .10, the option will move $.10 cents for every $1.00 move in the underlying stock.
Assuming you are long call options, the Delta would increase as the underlying asset moves higher and the Delta would decrease as the price of the underlying moves lower.
To give you a simple example, assuming you are trading call options, if you purchased a call option with a strike price of $50.00 while the stock was priced at $40.00, the Delta may be .10, but if the stock quickly increased in value and moved up to $48.00, over the next few days, the Delta would shift from .10 to .70, and the option would begin moving approximately $.70 for every dollar movement in the underlying stock.
Conversely, if within the next few days, the price of the stock moved back down to $40.00, the options Delta would decrease from .70 to .10 and the option would move only $.10 for every $1.00 in the price of the underlying stock.
The higher the Delta, the more the option would be worth, because options with high Delta react to price fluctuations very closely or similarly to the underlying asset; while options with low delta shift minimally in comparison to the underlying asset; so it’s simple to understand why options with higher delta are worth more than options that have lower Delta.
Both call as well as put options are categorized in one of three ways: at either at the money, out of the money or in the money. If the strike price of a call option is out of the money, it means that the option’s strike price is above the current price of the stock.
If the strike price is below the current price of the stock, then the option would be in the money and if the strike price of the option and the price of the stock are the same or very close to each other, then the option would be considered to be at the money.
Usually, an at-the-money call option will have a delta of about .50, and that’s because there should be a 50/50 chance the option winds up in- or out-of-the-money at expiration, so as expiration approaches, changes in the stock value will cause more dramatic changes in delta, due to increased or decreased probability of finishing in-the-money.
The Delta on a call option is lowest when the option is far out of the money and increases gradually as the price of the call option begins to increase.
The closer the options strike price moves towards the price of the underlying stock, the higher the Delta will become and the more the option will begin to react to change in price of the underlying stock.
To give you another example, if the stock is priced at $50.00 and you purchase a call option with a strike price of $60.00, the call option that you purchased would be considered out of the money.
If instead you purchased a call option with a strike price of $50.00, then the call option would be an at the money option and lastly, if you purchased a call option with a strike price of $45.00, then your call option would be in the money.
Put options work the same way, but the Delta moves in the opposite direction, I.E delta becomes more negative as the put option increases in value and becomes more positive as the put option decreases in value.
Therefore, the Delta on the put option is highest when the option’s strike price is substantially lower than the price of the underlying stock. As the asset moves lower, the option’s Delta decreases gradually.
As soon as the asset moves lower and trades at the same price as the strike price of the put option, then the put will become at the money and as soon as the option’s price is lower than the strike price of put option, then the put would be considered in the money and the Delta would decrease even further.
With call options Delta moves from o to 1, the lower the number the less sensitivity the Delta has to the price of the underlying asset.
With put options Delta moving from 0 to -1, so the lower the number the higher the sensitivity to the underlying asset.
As the price of the asset fluctuates, the Delta always moves higher and lower. The Delta represents at any given time the probability that the option will end up in the money at expiration and this is why options that are closer to being in the money have higher Delta levels and options that are further out of the money have lower Delta.
This is why paying attention to Delta on both the calls and the puts on at the money options can give you a great perspective on the current sentiment for the underlying stock you are analyzing.
Now that you understand the basics of Delta and how it shifts higher as well as lower as the price of the underlying fluctuates. I want to move on to the next issue, which is how to match the best strike price or the best Delta level to utilize for directional options trading. .
Unfortunately, just like most questions that involve options, there is no simple answer and the best way to decide which Delta level you need, is best decided by answering the following questions:
1. How big of a price move are you anticipating in the underlying asset?
If you believe that the underlying asset is going to move minimally, then I recommend you select options that are very close to being at or in the money, because options with low Delta or options that are far out of the money (assuming you are buying call options) will not have enough sensitivity to minimal fluctuations and won’t justify the cost of commission and slippage, unless the underlying price move is substantial.
If on the other hand you are anticipating a powerful price move, the buying options that are out of the money may make more sense; since the leverage that the out of the money option can offer you, can be substantial and if the move in the underlying is significant enough, the value of the out of the money option can sometimes move substantially and even multiply at times.
2. Do you believe the price move is going to occur in the next few weeks or the next few months?
If you believe that the price move is going to occur in the very near term, then buying an expensive options with less time value but higher delta (assuming you are buying call options) may be a good idea, since a shorter holding period will not cause too much decay in the price of the option.
If on the other hand, you anticipate a move over a longer period of time, possibly several weeks or even a month or two; buying an option with more time value and lower Delta may be a better choice; the higher time value gives more time for the underlying price move to occur; giving you higher probability or chance of participating and profiting from the underlying price move.
3. Is implied volatility on the low end or the high end?
If implied volatility is on the high end you may want to hold off buying the option or on the other hand consider selling premium instead. Sometimes however, options that have high implied volatility are expensive for a reason and make some of the best long candidates.
So if you want to buy an option and the volatility is on the high end, the option with the lowest implied volatility level will more than likely be options that are IN THE MONEY.
These options attract less speculative money and therefore have lower levels of volatility and speculative interest.
Similarly, not all options that have low implied volatility levels are good candidates for long positions, more often than not the reason why volatility is low is because the expectation for the underlying asset are not desirable at the current time.
In conclusion, always consider your trading objective when analyzing Delta levels and don’t forget to consider the time frame and implied volatility levels before initiating directional options positions.