Did you know…? In Nevada it is illegal to ride a camel on the highway. It is illegal to drive barefoot in Alabama. In Massachusetts it is illegal to drive with a gorilla in the backseat. In Florida you must pay the meter if you tie an elephant to it just as if it was a vehicle. And finally, in San Francisco, it is illegal to wipe your car with used underwear. Good law there.
Now that we have the basics down as to what an option is, let’s take a quick look at some of the ways we measure the behavior and characteristics of options. In the world of options we measure how they behave by what we call the Greeks. This has nothing to do with your old fraternity but rather variables that help us determine risk within an options or group of options. There are 4 main greeks that are utilized in the world of options – delta, gamma, theta and vega. There are a few more and second order derivatives as well, but the main four will serve 99% of what options traders need. Today we will cover the granddaddy of greeks – delta.
Options are derivatives. That means their value is determined from some other instrument or underlying. For example, when AAPL’s stock price moves, the value of all AAPL options move. The sensitivity of the option to changes in the movement of the stock or whatever underlying it is tied to is known as delta. So, if the delta is .50, then for every $1 move in AAPL the option price will move $.50. If AAPL goes from $460 to $461, the Mar (March) 460 calls go from $16 to 16.50. A .10 delta option will be expected to move $.10 for every $1 move in the stock. Deltas are reported as whole numbers or decimals. An at-the-money option will have a delta close to 50 or .5 depending on the report. Technically, puts have negative deltas. As stocks move up puts get less valuable and their price will fall. A put with a 70 (or .70) delta will move down in price by $.70 for every $1 rise in the stock and rise by the same amount if the stock falls.
Another way to think of delta is the probability of an option finishing in the money at expiration. As we pointed out above, an at the money options has a delta of around 50. Since the option strike price is close to the price of the stock there is about a 50/50 chance of the option finishing in or out of the money. Options with deltas above 50 are said to be in the money as if expiration occurred now they would be exercised. Options that have deltas less than 50 are said to be out of the money – they will expire worthless based on where the underlying currently is. Next week – gamma.