Editor’s note: Today, we’re keeping the spotlight on our colleague Market Wizard Larry Benedict.
In today’s essay, Larry shares an important tip that can help make you a more successful options trader.
Read on for more from Larry…
If you’re new to trading options, it can be difficult to understand the relationship between the underlying stock price and the value of an option.
For example, you might buy a call option in anticipation of a stock rallying…
But how much should the call option increase (or decrease) in value as the stock rises (or falls)?
That’s where the option’s “delta” fits into the picture.
Delta is one of the “Greeks.” Traders use this metric to gauge an option’s sensitivity to changes in the underlying security.
That is, it tells you how much an option’s price should move based on how much the stock price changes.
And while this can seem like a complex topic, a basic understanding of delta can help make you a more successful options trader…
Understanding Delta
You’ll find an option’s delta quoted on any option trading platform.
Deltas for call options are positive and range from 0.0 to 1.0. And a call option should increase in value when the underlying stock rises.
For put options, deltas are negative and range from 0.0 to −1.0. A put option’s value should decrease in value if the underlying stock price goes higher.
But delta is especially useful in telling you how much that change should be.
For example, a call option with a delta of 0.5 means that the option should change by around half the stock price’s move.
That means there would be a $10 increase in your call option if the stock price rises by $20.
And if the share price dropped by $10, you’d expect the call option to fall by $5.
(Incidentally, a 0.5 delta is typically what you’d expect for an at-the-money [ATM] option. That’s an option with a strike price that’s the same or very close to the stock price.)
Let’s check out an example to see how it works…
An Example in Action
In the image below, you can see a range of call options for Exxon Mobil (XOM).
The strike prices are on the right. And these options have roughly two months until expiry.
Exxon Mobil (XOM) Options
Source: Bloomberg
With XOM trading around $115, we can buy an ATM call option (orange box) for around $3.85. That’s $385 per contract (since each contract covers 100 shares).
With a delta of 0.5, this $115 call option should increase around $1 for a $2 rise in XOM’s price.
On the other hand, if XOM dropped by $2, our option would lose $1 in value.
But compare our ATM $115 call option to an out-of-the-money (OTM) $135 call option (red box).
We can see a big difference. Take another look:
Exxon Mobil (XOM) Options
Source: Bloomberg
The $135 call option would cost just 15 cents to buy – that’s a mere $15 per contract.
But its delta is just 0.03.
So even if XOM rallied strongly, it would have little impact on the call option’s value.
That’s only a three-cent increase in the call option during a $1 rise in the stock.
In this example, XOM would have to rally $33 to generate a $1 increase in the option’s value.
Compare that to a $2 stock move that can generate a $1 gain on our ATM calls.
The Right Balance
Ultimately, it’s a trade-off.
Buying OTM options is far cheaper than ATM calls.
Yet as our XOM example has shown, you’ll need a much bigger move to be profitable.
If the OTM option is very far away from the stock price, even a big rally (or plunge) in the underlying stock won’t shift the value of the options by much.
So when you’re trying to pick an option, the trick is to find the right balance between what you pay for the option and its delta.
Because that will ultimately determine the likelihood of your option’s success.
Good Trading,
Larry Benedict
Editor, Trading With Larry Benedict