When a trading strategy requires the use of options, it's very important to understand how option prices will react to changes in the underlying security.
At first glance, option pricing can appear relatively simple. The price of a call option increases as the underlying stock (or ETF) goes up, and the price decreases as the price of the stock declines. The price of a put option increases as the underlying stock's price falls and decrease as the stock rises.
But, of course, there are a lot of other factors in play. While the primary driver of option prices still remains the action in the underlying stock, option prices are also affected by volatility, time decay and interest rates, among other forces.The majority of trades that we recommend involve selling puts on stocks that we would like to own. These put contracts obligate us to buy shares if the stock drops below the strike price of the put contracts. If the stock remains above the strike price, we get to keep the income we receive, known as premium, when selling these contracts.
With a put selling strategy, we need to estimate the potential return and the amount of capital at risk. Our primary means for assessing where an option contract might trade and how much capital we are putting at risk is derived from assuming a worst-case scenario where our puts are assigned and we are required to buy the underlying stock.
We then determine how much capital would be at risk if the stock traded to a level where our assigned position was stopped out and sold.
This type of assessment is helpful for option contracts that are actually converted into a stock position, but it doesn't help tell us where an option contract will be trading before the assignment actually takes place.
Delta -- The Primary Measure of Option Price Movement
The options Greek delta refers to the degree to which an option contract reacts to a $1 movement in the underlying stock. The values range from 0 to 1 for call options and 0 to -1 for put options.
For example, a call option with a delta of 0.5 would be expected to increase $0.50 for every dollar that the underlying stock rises. If a call has a delta of 1, the price would be expected to move in lockstep with the underlying stock price.
A put option with a delta of -0.5 would be expected to increase $0.50 for every dollar that the underlying stock fell. And a put with a delta of -1 would move in line with the underlying stock price.
Delta is calculated for individual option contracts and is typically available as part of any standard brokerage platform or option charting or quote service.
The important thing to realize is that delta can change rapidly depending on the dynamics for a specific option contract. The two primary factors affecting delta are how far in or out of the money an option is trading and how much time is left until expiration.
In the Money vs. Out of the Money
The majority of put contracts that we sell are out of the money. This means that the strike price for the put option is below the current stock price, and the stock price must fall before we become obligated to purchase shares.
Delta decreases (moves closer to zero) for option contracts the further out of the money they are. This is because options that are significantly out of the money have a much lower probability of being exercised. So the less the likelihood that the put contract will be exercised, the less it is worth in absolute terms, and the less it matters if the stock moves up or down by a small amount.
In contrast, the further in the money an option contract is, the higher the delta (i.e., the closer to 1 for a call or -1 for a put) and the more in line the option will trade with the stock. If the stock is trading well below the strike price for our put contract, there is a high probability that the put will be exercised and we will be required to take delivery of the stock.
Of course, if the stock is trading fairly close to the strike price, there will be a material amount of uncertainty as to whether the option will be assigned. This is when it is particularly important to pay attention to the options delta to determine how much the underlying option contract will react to a change in the stock price.
The Amount of Time Until Expiration
The second important factor affecting delta is how long the option contract has until expiration. If an option is set to expire very soon, then there will be much more certainty as to whether the contact will be exercised.
In this case, if the option is out of the money, its nominal price and its delta will naturally migrate toward zero as expiration approaches. Because the option is unlikely to be exercised, it has very little value, and therefore, a small fluctuation in the underlying stock price won't affect that value very much.
If the option is in the money, the delta will naturally migrate toward 1 (call) or -1 (put) as time runs out. This means that pricing for the option contract will fluctuate more in line with the underlying stock because the probability of the option actually being converted into a stock position is very high.
The longer the amount of time until an option expires, the lower the delta measurement will be all else being equal. This is because a small fluctuation in the day-to-day pricing of the stock does not necessarily have a significant effect on the long-term expectation for the stock price when the calls or puts expire.
So, from a timing perspective, delta is higher when there is less time until expiration and lower when there is more time until expiration.
Putting Option Delta Into Practice When Selling Puts
From our perspective as put sellers, it is important to keep an eye on the delta of our option contracts so that we know what to expect in terms of profit and risk from our positions.
When we are selecting a put option to sell, the closer the delta is to zero, the more likely the put will expire worthless, allowing us to keep the premium we collected with no obligation to buy the underlying stock.
Once we have sold a put, if the delta for our contracts rises unexpectedly, this can be a good signal to take a close look at our position to make sure everything is still trading as expected. In this type of scenario, we are more likely to have the put contract assigned, leaving us with a long position in the underlying stock.
This can be a good thing as we are typically selling puts on stocks that we want to own. But we need to monitor the situation carefully in case the stock is breaking down for an unexpected reason.
(This article originally appeared on ProfitableTrading.com.)