This excerpt from Tom Gentile was originally published in "The Alpha 9 Trader Bible," a product of Money Map Press.
If you've traded options before, you've probably heard someone mention the "Greeks."
There are a number of them, and the formulas necessary to calculate them are quite daunting, to say the least.
Fortunately that's all done automatically by your brokerage.
But, understanding how these calculations effect the price of an option can be infinitely useful in understanding what makes an option tick... and where it could be headed next.
Here's the only thing you need to know.
The Best Way to Simulate Option Price Movement: "Delta"
Our main goal in trading options, of course, is to make money. But to make money on any trading, we need some way of finding out, ahead of time, how the security we're trading will move in price.
Luckily, when it comes to options, there's only one number you need to know: a number called "Delta."
To find this "Delta," the one number that will tell you how an option will move, all you have to do is master this formula:
Simple, right?
Don't worry!
Luckily, your broker will do all that for you. Here's what you need to know. This formula is used to calculate a number called "Delta." Delta is one of the option "Greeks" (they're called that because they are all named after Greek letters), a series of values that determine an option's premium.
The Delta is considered by many to be the most important component of any option, and can be used in a couple of different ways when trading. I'll show you both of these, and illustrate how paying attention to Delta can help you when determining which option to buy.
But first, we need to get clear on what exactly Delta is...
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Delta Tells You How an Option's Price Will Respond to Its Underlying Security
In simple terms, Delta is a numerical value given to each option that shows how much that option's premium will move with the next $1 move in the underlying security.
Deltas are either a positive number (for calls) or a negative number (for puts). In other words, call options will have a Delta anywhere from 0 to 1.00, whereas a put option will have a Delta anywhere from -1.00 to 0.
Here's a quick example: take a stock trading at $50, with a call option on that stock that has a Delta of 0.60. That means that when the stock goes up $1.00 in price, the premium of the call option on that stock should, on its Delta component alone, go up in price by $0.60. On one contract, that means an increase of $60 ($0.60 x 100 shares = $60), since one contract gives you control of 100 shares.
Here's another example, this time with a put on that same $50 stock. If the put option has a -0.60 Delta, that means that when the stock drops in price by $1.00, the premium of the put option on that stock should, on the Delta component alone, go up $0.60, or $60 per contract.
Mind you, the Delta will work against you by that same amount should the stock move against you. For example, if you have a call option with a 0.60 Delta and the stock drops $1.00, that call option should drop that 0.60, or $60 on the contract.
Now, here's how you can use Delta in practice.
How to Use Delta to Calculate Potential Gains
As I mentioned, there are two main ways to use Delta when trading options. The first is to use Delta to figure out how much you can expect the premium of an option to change for every $1.00 up or down move in the underlying stock.
Here's a quick example, using Monsanto Co. (NYSE: MON) at a closing stock price of $90.83 (on October 19, 2015).
As you can see, these MON call options have a Delta of 61.06%, or 0.61, and the option premium is $3.65. So, how many 0.61 moves will it take to add another $3.65 to the option's premium and double your money? Well, $3.65/0.61 = 5.98, so roughly six.
So just off the Delta alone, you can "guesstimate" that a six-point move higher in the price of the underlying stock (in this case, a $6 move higher in MON shares) should double the value of your call option...
Now, while Delta is usually all you'll need, the true calculation will be slightly more complicated. You see, another thing to keep in mind is the Gamma, another "Greek" that tells you the rate of change in the Delta. The Gamma shows you how much the Delta will change with each dollar move in the stock. For example, if the Gamma is 0.05, that means the Delta should increase by $0.05 for every dollar move.
In case you're interested in all the option "Greeks," here they are:
Now, let's put it all together and see how to use Delta to find the best trades.
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How to Use Delta to Find the Best Trades
The Delta value of an option also plays a direct role in determining that option's profitability. An option's moneyness (that is, whether it's In-the-Money, At-the-Money, or Out-of-the-Money) directly impacts the Delta value.
More specifically, the Delta tells you the probability the option will end up In-the-Money (ITM) at expiration. Here's what I mean...
Remember, the highest Delta you can get on an option is 1.00. And an option with a Delta of 1.00 is pretty much the closest thing you have to a 100% chance of the option ending up ITM.
At-the-Money (ATM) options typically have a Delta of 0.50, meaning they have a 50% chance of being ITM at expiration. Of course, that also means that there is a 50% chance that they end up Out-of-the-Money (OTM).
When I buy ITM options, the intent is to have them end up more ITM before I sell (or exercise) them than they were at purchase. So if I start out with an option with a Delta of 0.70, and that Delta then increases and moves closer to 1.00, my option's premium will be increasing in price at an accelerated rate.
Here's why this understanding of Delta is important: an OTM option with a Delta of 0.25 has only a 25% chance to end up ITM. When the option's moneyness goes from OTM to ITM, the option should be increasing in value.
The option can also go from OTM to ATM, and the option should be increasing just on the Delta component, but that is not a guarantee.
On my "vanilla" options trades, I personally like to look for an ITM option with a higher Delta in the sweet spot of 0.70-0.75. In these trades, I want the underlying stock to move within 30 days.
Because I need the stock to move quickly and I want to make more money on each one-dollar move the underlying stock makes in my direction, the ITM options with the higher Delta usually pay out better than those that are OTM.
ITM options also allow me to protect my capital better than OTM options, because I am able to recoup more of my option premium in the event the stock trades flat. When trading options, this is good to keep in mind. We need to know ahead of time how our option's premium will move relative to the price of the underlying stock as we get closer and closer to the expiration date.
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Understanding "the Greeks" is a key wealth-building weapon in every trading expert's arsenal.
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