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Saturday, September 24, 2011

Behaviour of DELTA in relation to TIME REMAINING TO EXPIRATION – With Past DATA and CHARTS

The following is the behavior of Delta in relation to Time to Expiration:

Assume all other factors unchanged:
As the time to expiration is nearing, the Delta of ITM options increases (i.e. ITM option’s Delta gets closer to 1 for Calls or to -1 for Puts) and the Delta of OTM options decreases (i.e. OTM option’s Delta gets closer to 0).

Now, let’s observe using the past real data.
The following is the Options Chain for Call options of RIMM as at 3 Sep 2010, when the closing price is $44.78 and Implied Volatility (IV) is 54.05, for expiration month of Sep 2010 (10 days to expiration), October 2010 (38 days to expiration) and Dec 2010 (101 days to expiration).
(The rows highlighted in yellow are ITM options, while those in white are OTM).

For easier reading and comparison, I summarize the Delta for different time to expiration as follow:

As can be seen from the table, for ITM options (highlighted in yellow), the Deltas are the highest for the expiration month “Sep-10” (nearer to expiration), followed by “Oct-10”, and then “Dec-10” (further to expiration).

On the other hand, for OTM options, the Deltas are the lowest for the expiration month “Sep-10” (nearer to expiration), followed by “Oct-10”, and then “Dec-10” (further to expiration).

For near ATM options (i.e. the option’s strike price $45.00, because the stock price is $44.78), the Delta is about the same, i.e. close to 0.5.

These observations are in line with the statement above.

In addition, we can also look from different point of view, i.e. by comparing Delta at various strike prices at different time to expiration, as shown in the chart below.

From the chart, we can see that:

The effect of stock price changes on the option price (i.e. Delta) are more “extreme“ for ITM and OTM options with nearer time to expiration, as compared to those with further time to expiration.
Nearer time to expiration will push the Deltas of ITM Calls closer to 1 (-1 for Puts) and the OTM option’s Delta closer to 0.

In contrast, for ATM options, the Delta is relatively unaffected to changes in time to expiration, i.e. all will have Deltas close to 0.5.

So, what’s the implication?
We can use this knowledge to help us consider and choose which options to use for trading, given the trading opportunities, expectation of whether the price movement is big or small, expected time frame, and options strategies.

For instance:
If you’re playing a swing trading and expect a stock’s price will change moderately within a short period, and you want to buy a straight Long Call to take advantage of this opportunity. In this case, you could consider using ITM options from a nearer time to expiration, as this option has higher Delta. Hence, when the stock price indeed increases as expected, you can gain more (in terms of dollar) from the increase in the option’s price.

However, given the scenario, suppose due to capital constraint, you would like to use OTM options, then choosing OTM options from a longer time to expiration should be better to take advantage from the stock price movement (in terms of dollar), as this option has higher Delta.
(Note: This is just a simple example about how to make use of the knowledge on Delta behavior in your trading. Actually, using OTM options in such case would have lower chance to be profitable, as an OTM option would require a very big increase in the stock price for the option to be profitable.)

The bottom line:
Whatever strategy you use, do consider the behaviors of the Option Greeks to help you choose which options to use (ITM, ATM, or OTM) to enhance the probability to make money.

Next, we’ll discuss about the behavior of the rest of the Options Greek.

To view the list of all the series on the this topic, please refer to:

Other Learning Resources:
* FREE Trading Educational Videos with Special Feature
* FREE Trading Educational Videos from Trading Experts

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

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