We discussed in the articles earlier in the series how options contracts pricing is derived from the underlying stock. Delta is the amount an option price is expected to move based on a $1 per share change in the underlying stock. The Delta of a call option ranges from 0 to 1, and the delta of a put ranges from 0 to -1. Traders will often drop the decimal point for simplicity and say 0 to 100 and 0 to -100. Options contracts do not have an exact correlation with the stock price. Options have a different cost basis than the underlying stock, and as a result, move differently than the stock. A 1% increase in the stock value will not result in a 1% increase in your options contract value.
How Delta Changes
Understanding how an option contracts delta changes us will tell us how much the premium of an option will change, determining how much our options contract will appreciate or depreciate in correlation to the stock price. The further delta is from 0, the more of an effect a price movement in the stock will affect the premium. Call contracts have a positive delta, and put contracts have negative.
If we purchase a 10 delta call on a stock and it goes up by $1, the premium on the contract would increase by $0.20. If we purchase a 100 delta call in the same scenario, our premium would increase by $1. It works the same in put contracts but inversed. If you buy a 50 delta put, and the price of the stock decreasing by $1, our premium would then increase by $0.50.
What It Tells You:
In general, In-the-money contracts will move more than out-of-the-money options, and short-term options will react more than longer-term options to the same price change in the underlying stock. As a contract expiration date approaches, the delta for in-the-money calls will approach 1, reflecting a one-to-one reaction to price changes in the stock. Delta for out-of-the-money calls will approach 0 and will not react to price changes in the underlying asset. Here’s why: If they are held until expiration, calls will either be exercised and “become stock” or they will expire without any value.Vice-versa for puts. As expiration approaches, the delta for in-the-money puts will approach -1 and delta for out-of-the-money puts will approach 0. That’s because if puts are held until expiration, the owner will either exercise the options and sell stock or the put will expire worthless. This is a crucial concept for understanding why an option contract is valued at what it is!
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