Using the Option Delta

The Option delta is a great way to predict how much an option will increase or decrease as the stock moves one way or another, but how do you use it?

A delta is a number between 0 and 1 that estimates how far a stock option is likely to move for every 1 point move in the stock.  Every option has a different delta because of things like time value, and strike price. 

So how do you use it? Let’s look at an example.  Say we are expecting a stock to make a quick move from $55 to $65.  To play this we are buying an option 2 months out with a strike price of $50.  This option cost $7 and has a delta of $.70. 

So if the stock does move in our favor $10 the delta should also move in our favor .7 *10 or $7.  In other words we would be expecting the option to double to $14 if the play goes our way. 

We can also use the delta to calculate risk, so if we decide we want to exit the trade if the stock goes to $50 we can estimate how much that would cost us.  We would lose $.7 * 5 or $3.5 which is ½ of the value of the option.

Of course this is all just an estimate and not the actual figure.  There are so many factors that go into prices an option that this will not be a spot on theory.  Two such factors are.

1.       Time Value

As the option approaches expiration the time value will negatively affect the options price.  So the more time that passes the less the option will be worth.

2.       Deeper in the money

As the stock goes up the option will become deeper in the money and therefore the delta will likely increase, so it may not be $.70 + $.70 + $.70 but $.70 +$.72+$.73 …

Even so the delta is a good instrument for measuring how the price of a option will be affected when the stock moves.

For more information on option delta visit  http://www.stocks-simplified.com/option_delta.html