Definition and Examples of Delta
Delta measures how the price of an options contract changes in relation to changes in the price of the underlying asset. Delta is one type of Greek value used to describe changes in the value of an option. Understanding delta can help investors implement a hedging strategy using options.
Alternatives to Delta
Delta is just one of the Greek symbols used to describe or analyze changes in options values. Greek letters Vega, Theta, Gamma, and Rho are also used. Vega measures the expected changes in options prices based on the volatility of the underlying asset. Theta: The values of options are partially affected by the time remaining before expiration. The portion of an option’s value that exceeds its current intrinsic value due to this time is known as time value or time premium. Theta measures the rate of decline in the value of an option over time, known as time decay. Gamma: It is a derivative of delta, measuring the rate of change of delta relative to the change in the price of the security. If the value of the security increases or decreases by $1, gamma illustrates how that impacts the option’s price. Rho: It measures the effect of changes in risk-free interest rates on the option’s price, expressed as the amount of money a single option would lose or gain with a 1% change in interest rates.
What This Means for Individual Investors
An investor can use their understanding of delta to implement an options strategy to protect themselves by offsetting changes in the price of the stocks they own. This type of strategy is called a hedging strategy, and delta options are used to calculate the hedge ratio.
Let’s assume the investor owns 100 shares of a particular stock, and the corresponding call option has a delta of 0.25. Again, this means the price of the option will increase by 25 cents for every dollar increase in the stock price. The investor can use this relationship to their advantage in the hedging process by writing calls, also known as writing options.
To know how many calls to write to offset the change in the stock price, one simply takes the reciprocal of the hedge ratio, which is 1 / hedge ratio. In this case, 1/0.25 = 4. To hedge this position in the stock, the investor must write four calls.
To understand how to hedge the investor’s position, remember that a standard options contract represents the right to buy or sell 100 shares.
If the investor owns 100 shares and the price of each share falls by one dollar, their long position in the stock has decreased by a total of $100. Since each options contract represents 100 shares, the price of each contract decreases by $25 (at a rate of 25 cents per share). Four contracts decrease in value by $25 each, equating to $100. The investor can buy these contracts back in the open market. If the investor bought the contracts back, they wrote them for $100 less than they received when they sold them, effectively offsetting their loss on the stock.
The investor can also use delta as an estimate of the probability of whether the option will be in the money, meaning, using call options as an example, that the current price of the underlying asset is higher than the agreed-upon strike price at expiration. In this application, the delta value is simply expressed as a probability. Here, it will be used to interpret that the contract has a 25% chance of being kept in the money.
How to Obtain Delta
Delta is part of the Black-Scholes options pricing model. While you can calculate it yourself using the Black-Scholes model, it is also available to you through options quotes and may be provided by the brokerage firm you use for options trading.
Source:
Leave a Reply