Options traders can fall into a trap when they’re first starting out.
They look at the available options and see they can pay $1,000 for an option at one strike price… or just $100 for another at a different strike.
Obviously, paying less for your option seems like an attractive choice.
But there’s a downside that new traders can overlook…
Say, for example, you buy that cheaper call option in anticipation of a stock rallying…
Then the stock surges higher. But your option’s value barely shifts.
It doesn’t make any sense…
But that’s where the option’s “delta” fits into the picture…
Delta reveals an option’s sensitivity to price changes in the underlying asset.
It tells you how much an option’s price should move when the underlying stock price changes.
And it can help you avoid this common pitfall when choosing which options to buy…
How Much Change to Expect
You should find an option’s delta quoted in any options trading platform. (Your broker might not display it by default. If it isn’t visible, try adjusting the settings to show delta.)
Deltas for call options are positive, ranging from 0.0 to 1.0. It’s positive because the call option should increase in value when the underlying stock rises.
For put options, deltas are negative, ranging from 0.0 to −1.0. The put option’s value should decrease if the underlying stock price rallies.
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 move about half the stock price’s move.
So if the stock price increases by $20, the call option should increase by $10. And if the share price dropped by $10, you’d expect that call option to fall by $5.
You typically find a 0.5 delta with an at-the-money (ATM) option. That refers to an option where the strike price is the same or very close to the current stock price.
So, let’s check out an example to see how it works…
Comparing Deltas
Consider Nvidia (NVDA) – one of the biggest movers over the past year.
NVDA is trading near $120. We can currently buy an ATM call option for $10. So we’d pay $1,000 per option contract. (An options contract is for 100 shares, so 100 × $10 = $1,000.)
With its delta of 0.5, our $120 call option should increase by $1 for each $2 rise in NVDA’s price.
But contrast that with an out-of-the-money (OTM) option with a strike far above the current stock price.
We can see a big difference…
A $160 call option costs just $1.00 to buy. That’s $100 per contract (100 × $1 = $100).
But the contract has a delta of just 0.05.
With such a low delta, even a strong rally would have little impact on the call option’s value. We’d only see a $0.05 increase in the call option for a $1 rise in the stock.
NVDA is unlikely to move dramatically enough for us to see a significant return on our options.
|
Free Trading Resources Have you checked out Larry’s free trading resources on his website? It contains a full trading glossary to help kickstart your trading career – at zero cost to you. Just click here to check it out. |
The Right Balance
As you can see, it’s a trade-off…
Buying OTM options is far cheaper than ATM.
But if you choose a strike price too far out, you’re greatly reducing your chance of success.
With an OTM option so far away from the stock price, even a big rally in the stock won’t flow through to the options very much.
And time decay eats away at the value of the option. So it’s likely to expire worthless.
So don’t choose options based on their cheap price…
Consider an option’s price along with its chance of success.
The trick is to find the right balance between the price you pay for the option and the option’s delta.
Because that will ultimately play a big role in your trade’s success.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict