Options 101: What is Delta?

Photo by Moritz Mentges on Unsplash

Delta is a commonly known word that is associated with major US commercial aviation provider Delta Airlines and delta in mathematics that describes a change in something.

However, in the world of liquid derivatives, Delta is a tool used to justify and adjust different entries & exits.

So what is delta, sounds like just a cool word to me?

Let’s get right into it 💪

DELLTAAAAA 🔺

In Laymen’s terms, data is the measurement of an option’s change in price from a $1 increase/decrease in the underlying ticker.

The 4 functions of delta are as follow:

• Probability of ITM
• Directional Risk
• Traction
• Hedging

1. Traction 🚜

Delta traction is pretty simple and illustrates the idea that option delta can range from 0 to +1 and from -1 to 0.

0–1 means positive delta and tells us that if we have a delta of X, then when the stock moves up $1, our option will gain the value of X.

On the contrary, -1–0 would mean that an increase in the stock price would decrease our options price by X and go up when the underlying goes down.

It’s also important to understand that since options give us the ability to leverage capital, buying options will result in lower BPR but also less reward intrinsically (assuming all constant variables).

2. Directional Risk 🔄

The beauty of options resides in the fact that you’re able to put on positions that either possess direction or are delta zero (aka neutral).

Going back to traction, positive deltas signify a bullish market assumption while a negative delta assumes a bearish market.

Personally, I prefer to keep my positions delta neutral, meaning I tend to have a neutral market assumption and rely more on time until expiration compared to a move in the underlying.

This would then result in my portfolio not really caring about which direction the market moves in allowing me to be both bearish and bullish on the markets. (kangarooish?)

Understand that whatever delta position you take and how a direction opposite to your market assumption will impact your positions.

3. Hedging 🐐

According to the tastytrade website, hedging is described as so

We are referring to reducing our risk. When we hedge a trade, we are limiting our profitability while at the same decreasing the amount of risk we are taking. https://www.tastytrade.com/definitions/hedging

Basically, hedging is an act of purchasing products that profit off of the potential original trade losses.

Ex. We are long 300 shares of CHPT (I like this stock a lot by the way 😂)

This would make us long 300 long deltas because with each $1 increase in the share price we would profit $300 dollars.

We could semi hedge this 300 share position with 3x covered calls at a -30 delta per contract which would give us 90 short deltas or net 210 long deltas.

Full hedges with options work similarly as you try to fully offset your delta in the short run by selling an equivalent amount of contracts that offset long and short deltas. This would be relatively short-lived as gamma accelerates the change in delta dependent on the stock’s move, nonetheless still able to give a full hedge temporarily.

This specific way of hedging would reduce our cost basis, allow premium collection, and reduce directional risk.

4. Probability of Profit aka ITM

Image By Tastytrade

Option deltas also show us the probability of profit for each contract that we sell whether it be calls or puts.

POP (Out of the Money Percentage)=1- delta

Ex.

• -25 OTM Short Call = 25% Prob. of ITM or 75% OTM
• +50 ATM Short Put = 50% Prob. of ITM or 50% OTM

As premium sellers, we usually want our positions to be OTM to avoid assignment risk. That’s why premium sellers never sell ITM as the probability of profit is significantly lower despite the higher premium collected.

5. Conclusion

• Delta is one of the most important greeks to understand as it determines the risk/exposure of our positions based on a directional assumption.
• Delta can be used for both bullish, bearish, and neutral assumptions in the market.
• Can be used to offset risk and is an essential way to manage risk in any type of successful trading

6. My Position

• As of writing this article, I have 100 shares of CHPT at a cost basis of $22.00
• I entered this trade with net 100 long deltas and decided to sell a -33 delta covered call collecting premium and reducing my cost basis.
• My max profit held until expiration is now $700+premium
• But with each $1 move in the share price = long 66 delta, I now only collect $66 as opposed to $100
• Because I’m not fully hedged I’m more skewed to the upside as I’m not fully hedged. This would require 2 more naked contracts that I’m unable to cover. However, covered call mitigates risk to the downside and brings my position closer to delta-neutral.
• Looking to hold this position until expiration as I’m willing to let it go @$29 but will look for opportunities to either roll out the position for a profit or close at %50 of the premium received.

THANKS FOR READING⚡️

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— Tristian Xu