Option Greeks: DELTA (Part 2)

Go back to “Delta - Part 1”

Factors That Affect Option’s Delta
There are a few factors that influence option’s Delta:

a) How close or how far away the stock price from the strike price.
At-the-money (ATM) options have deltas around 0.5; Out-of-the-money (OTM) options have deltas between 0 to 0.5; In-the-money (OTM) options have deltas between 0.5 to 1. (The delta values will be positive for Calls & negative for Puts).
When options are deep OTM, they have a small delta, because changes in the stock price will lead to only small changes in the option price. But as the options move towards in the money resulting from a continued rise in the stock price, the delta gets larger.

As the stock price moves and an option gets deeper ITM, delta will change and would be approaching 1 for Call and –1 for Put. When the delta is near 1 for Call or -1 for Put, the options will begin to trade like a stock, moving almost dollar for dollar with the stock price. This occurs with little or no time value, as most of the value of the option is intrinsic.

Example:
ABC stock is currently trading at $50. The price of May 50 Call option (ATM option) is $3. The ATM option’s delta is 0.5. If the stock rises by $1 from $50 to $51 (all other factors unchanged), the option price will theoretically increase by $0.5 from $3 to $3.5. So, if we own one contract (long position), we will gain $50 (=0.5 x 100 shares/contract).
Now, if the stock rises $1 further from $51 to $52, will the option price move $0.5 again, or more or less than that? The answer is more than $0.5. Because when the stock was trading at 51, the option’s delta should be about 0.60, so when the stock made another $1 move, the option price will increase $0.6, from $3.5 to $4.1.

b) Changes in volatility and time to expiration.
Changes in volatility or time to expiration will change delta. Even though the stock price does not move, delta will change when there are changes in volatility or time to expiration.
However, for ATM options, the delta is relatively unaffected to changes in volatility or time to expiration. This means both ATM options with 90 days and 30 days to expiration will have deltas close to 0.5 (Assuming other factors constant).

In contrast, for ITM & OTM options, the more ITM or OTM an option is, the more sensitive its delta is to changes in volatility or time to expiration.
Fewer days to expiration or a decrease in volatility will push the deltas of ITM Calls closer to 1 (-1 for Puts) and the OTM options’ delta closer to 0.

The Impact of Time Remaining To Expiration on Delta
An option’s Delta does change as one trading day passes. This is often called as “Delta Decay”.
As the expiration is nearing (time to expiration gets shorter), the time value portion of an option is declining (time decay effect). This causes the delta of ITM options to increase (i.e. ITM option’s delta gets closer to 1 for Calls or to -1 for Puts) and the delta of OTM options to decrease (i.e. OTM option’s delta gets closer to 0).

As a result:
For ITM options, for the same strike price, the longer days to expiration, the lower the delta. Hence, a next month ITM option will have a lower delta than the current month option.
On the other hand, for OTM options, for the same strike price, the longer days to expiration, the higher the delta. So, a next month OTM option will have higher delta than the current month option.

The Impact of Implied Volatility (IV) on Delta
When volatility increases, the time value portion of the option will rise. As a result, the delta of OTM options goes up, whereas the delta of ITM options goes down.

c) Changes in stock price.
The option’s delta changes when the stock price changes. The sensitivity of delta to the movement of the stock price is measured by Gamma.

Continue to “Delta - Part 3”.

To read about other Option Greeks, go to: Option Greeks.

Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Learning Candlestick Charts
* Learning Charts Patterns