One of the most popular and widely used options greek is Delta. And while I believe that you can’t necessarily learn about option pricing and option greeks in a vacuum as they all work together to represent potential price action for changing market conditions, having a solid understanding of how Delta works is important both in entering new positions and managing your basket of trades in a portfolio. Today’s show dives a little deeper into the lead greek and covers both a basic understanding of what Delta is and how it works, plus some more high level insights into how I used Delta to enter our recent trade in XLE.

Key Points from Today’s Show:

  • Delta is a big component of options trading.
  • At the very basic level, Delta is one of the four main Greeks used in options trading. 
  • In options pricing, Delta does not predict where the market is going to go.
  • The Delta simply tells you how the option contract will react in pricing to different market scenarios. 
  • Delta is exactly how much the option price will change if the stock moves up by $1
  • Delta is not constant and is always changing as it reacts to the market, making it useful for probabilities.

Example 1: If the stock goes up by $1 and you have an option contract that has a Delta of 0.5, then the option price will increase by 50 cents or $50. Now, if you have a Delta of 0.3, then if the stock moves up by $1 the options contract should increase (all things being equal) by 0.3 — another $30. 

Example 2: If you have a put options contract with a Delta of -0.5, that means if the stock goes up by $1 your contract should go down in value by 0.5. 

*Everything is related to the $1 move.

Understanding Delta

  • The key to understanding Delta is knowing what type of contract you have and where you want the market to go.
  • Delta will then help you understand the type of movement your contract will have relative to that $1 move. 

Example: If the stock goes up by $10 and you have a Delta of 0.5, that contract will increase by $5. Then, if you have a Delta of -0.5 on a long put option and the market goes up by $10, the contract will go down by $5. If the value of the contract is only $4, then it will just go to $0.

  • If you think about Delta as the equivalent number of shares that you are holding in that security, it helps to simplify the concept of how pricing works. 
  • If you have a Delta of 0.3, that is the equivalent of holding 30 shares. 
  • A Delta of exactly 1, would be the equivalent of holding stock — 100 shares of stock.
  • This mindset helps you understand the price movement that you might see in the options contact based on where the stock goes in the future.

Options Selling

  • With option selling, you have to reverse your thinking in regards to Delta.

Example 1: If you have a short call option with a Delta of 0.3, it shows that you are exposed to bearish movements in the underlying stock — 30 shares of equivalent holding value or risk if the stock rises. 

Example 2: If you have a Delta of 0.2, this means that you are not as exposed to a huge run in the stock. If the stock runs up or makes a $1 move higher, then there is no as much exposure as if you had the 0.3 Delta call options. 

Delta Options Trader Mindset

1. Using Delta as a rough approximate for the probability that a stock lands in the money. 

Example: If you have a stock that is trading and the call option has a Delta of 0.3. That 0.3 could give you a rough approximate that there is a 30% chance that the stock lands in the money at the strike price, and a 70% chance the stock lands out of the money and never gets to the strike price by expiration. This creates a good benchmark for the probability. 

  • When you are selling options, you can use these Delta’s as a quick check or approximate representation of how likely you are to be successful selling those contracts.

Example: Selling a 30 Delta call option gives you about a 70% chance of success, and 30% chance of failure.As you get closer to expiration, the Delta of in the money options starts to increase and it starts to trade and react closer to how the regular stock would trade.

*Anything in the money at expiration converts to shares of stock.

  • Out of the money contracts start to see their Delta value decrease dramatically, as you get closer to expiration. 

Example: With an out of the money call option, as you get closer to expiration, that call option is less and less likely to be hit. So the Delta value goes down, which also represents that there is a lower probability that the market rallies to that strike price or beyond by expiration. 

  • As IV increases, it causes Deltas of out of the money options to increase.
  • This happens because market participants are assuming that the stock is going to make a big move.
  • As Deltas increase, this puts more weight on out of money options as it increases their risk of being hit.

Example: If you had an options contract that was $10 out or $15 out of the money, if there is a big move expected, now those contracts are back on the playing field. As the Deltas increase, this also increases the probability of the options to go in the money.

*Therefore, as an option seller, you do not want IV to increase.

2. Using Delta to calculate your portfolio balance.

  • Using Delta gives you a good representation of how balanced or unbalanced your portfolio might be, as a whole.
  • On most broker platforms, the software takes all of your Deltas and Betas of the underlying stock and concerts them to one big S&P position. 
  • This shows you what your portfolio would look like if it consisted entirely of S&P, giving you one benchmark.
  • Giving yourself the ability to look at how your portfolio is tilted helps you build out more positions or remove positions that are risky, giving your portfolio more balance. 
  • If for example, your Beta-weighted Delta’s are extremely high, you know that you need to add some bearish exposure to your portfolio. 

Example: If you Beta weight your portfolio and your portfolio has a Beta-weighted Delta of 7, that means for every $1 that the S&P goes up, it’s estimated that your portfolio actually makes $7. This shows you that your portfolio has some bullish exposure because if the market goes up, that is generally good for your portfolio. 

*If you have a large portfolio, a Beta-weighted Delta of 7 is not going to be that much. However, if it is a small portfolio, a Beta-weighted Delta of 7 might be high. 

*The goal is to be as balanced to the market as humanly possible, all the time. 

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
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  • Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.
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Option Trader Q&A w/ Max

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Max, who asks:

Do you have any recommendations or suggestions on profit loss visualization API’s, plugins, or code that we can use inside of Thinkorswim? I am familiar with the risk profile chart that is available in Thinkorswim, but I was looking for something that can be overlaid on top of the underlying candlestick chart. The closest example I have is the option visualization spread that’s available in TC2000. Do you have any recommendations on anything like that that can be overlaid on top of the candlestick chart in real time for Thinkorswim, or any additional tools that we can use?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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