Papale on Understanding Delta

Sell in May…go away.  That is the old adage.  Yesterday with the Dow down 138, it seemed we should be following those directions again this year.  Not sure exactly why that pattern holds true but market observers have been uttering that sage advice for years now.  So I will do what they say and sell in May and go away.  The Cubs that is.  Works every time.  At least the last 100 years or so.

Be careful when interpreting delta as the probability of an option or strategy finishing in the money.  While that is one correct way to think of delta, and we discuss it in our mentoring program, it does not consider the path the option may take along the way to expiration.

For example, an investor sells an out of the money put with a delta of 20.  This can be interpreted that there is a 20% likelihood that the put will end up in the money at expiration.  Sounds like a pretty safe bet.  And statistically 80% of the time those options will finish out of the money and be worthless.  However, the market tends go up and down along the way and the delta can often move around as well.  What that means is if you are managing risk during the trade you might in fact be taking losses along the way – much more than 20% in this example.  Risk management is designed to keep our losses manageable. You could be passive and let the statistics work and over time they would play out.  However the loss could potentially be so big it could put you out of business.  Recognize how probability and risk management interact and how that might affect your bottom line – and your longevity as a trader.

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