Mar 18

Intro to option greeks: delta and its determinants

Intro to option greeks: delta and its determinants

I started trading stocks in 2010. I didn't expect to make big profits and wasn't actively trading. That's until 2015, when I met a guy who turned $10,000 into $140,000 in four years. And then I thought: why am I fooling around when it's possible to make good money? Experienced traders say: trading is a journey. That's how my journey started. Stocks move too slowly, to my taste, so I had to look for other avenues.

Two things were clear to me. I didn't want to be glued to the monitor the whole day and didn't want to study a lot of theory. Therefore I decided to concentrate on the futures market. To trade futures, you don't even need to know the definition of a futures contract. The price moves very quickly, and if you know what you are doing, you can make a couple of hundreds in a matter of minutes. It turned out that the futures markets are the best approximation to the efficient market hypothesis. Trend is your friend (until the end), as they say. In the futures markets, trends are rare and short-lived. Trading futures is like driving a race car. The psychological stress is enormous and it may excite your worst instincts. After trying for almost two years and losing $8,000 I gave up. Don't trade futures unless you can predict a big move.

Many people start their trading careers in the forex market because the volumes there are large and transaction fees are low. I never traded forex and think that it is as risky as the futures market. If you want to try it, I would suggest to trade not the exchange rates themselves but indexes or ETF's (exchange traded funds) that trace them. Again, look for large movements.

One more market I don't want to trade is bonds. Actions of central banks and macroeconomic events are among strong movers of this market. Otherwise, it's the same as futures. Futures, forex and bonds have one feature in common. In all of them institutional (large) traders dominate. My impression is that in absence of market-moving events they select a range within which to trade. Having deep pockets, they can buy at the top of the range and sell at the bottom without worrying about the associated loss. Trading in a range like that will kill a retail (small) investor. Changes in fundamentals force the big guys to shift the range, and that's when small investors have a chance to profit.

I tried to avoid options because they require learning some theory. After a prolonged resistance, I started trading options and immediately fell in love with them. I think that anybody with $25,000 in savings can and should be trading options.

Definition. In Math, the Greek letter \Delta (delta) is usually used to denote change or rate of change. In case of options, it's the rate of change of the option price when the stock price changes. Mathematically, it's a derivative \Delta=\frac{\partial c}{\partial S} where c is the call price and S is the stock price. In layman's terms, when the stock price changes by $1, the call price changes (moves in the same direction) by \Delta dollars. The basic features of delta can be understood by looking at how it depends on the strike price, when time is fixed, and how it changes with time, when the strike price is fixed. As before, we concentrate on probabilistic intuition.

How delta depends on strike price

Intro to option greeks: delta and its determinants

Figure 1. AAPL option chain with 26 days to expiration

Look at the option chain in Figure 1. For the strikes that are deep in the money, delta is close to one. This is because if a call option is deep in the money, the probability that it will end up in the money by expiration is high (see how the call price depends on the strike price). Hence, stock price changes are followed by call price changes almost one to one. On the other hand, if a strike is far out of the money, it is likely to remain out of the money by expiration. The stock price changes have little effect on the call price. That's why delta is close to zero.

How delta depends on time to expiration

Intro to option greeks: delta and its determinants

Figure 2. AAPL option chain with 5 days to expiration

Now let us compare that option chain to the one with a shorter time to expiration (see Figure 2). If an option is to expire soon, the probability of a drastic stock movement before expiration is low, see the comparison of areas of influence with different times to expiration. Only a few options with strikes lower than at the money strike have deltas different from one. The deeper in the money calls have deltas equal to one: their prices exactly repeat the stock price. Similarly, only a few out of the money options have deltas different from zero. If the strike is very far out of the money, the call delta is 0 because the call is very likely to expire worthless and its dependence on the stock price is negligible.