Understanding an Options Delta In ThinkOrSwim

csricksdds

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Delta is one of the Greeks related to trading options. In short a Delta measures mathematically how much an option price is expected to change for every $1 price movement in the value of the underlying security (stock, ETF, etc.).

The easiest visual for a Delta is a $1 bill on both the Call and Put side of an option chain. The current price of a stock is called ATM (At-the-Money) and is always located at the 50 cent level (50 Delta) of the dollar bill. It is at the 50 cent level because it has a 50% chance to go up in value, down in value, or not move in price at all. It’s like the 50 yard line in football where we don’t know if the team controlling the football is going to gain yardage, lose yardage, or not move the ball at all. The football field is 100 yards or $1 for each yard with the 50 yard line always at the center).

Again, the market uses the 50 cent level (50 Delta) for the At-The-Money security price because the market doesn’t know whether the stock price will increase, decrease, or stay flat in value. Since a dollar has 100 pennies it also has a total of 100 available Delta’s.

So, how do Delta’s work?

If you buy a 50 Delta Call and the stock moves up $1 dollar in price you can expect to make $50 on the price paid for the option (i.e. 50 cents times the 100 shares controlled by the option = $50). If the stock moves down $1.00 in price you will lose $50 of the amount paid for the option.

It is important to note that a delta functions the same regardless of the price paid for the option. If you pay 3.00 for an option and the stock price goes up $1 you will make $50 profit on the option. If you paid $1 for the option and the stock price moves up $1 in price you will still make $50 on your option.

In the first case above you paid 3.00 and received 3.50 if you sold at that $1 price increase for an 11.66% return. In the second you paid $1 and received $1.50 if you sold at the $1 price increase for a 50% return. This comes under the heading “Risk to Reward.” It works in just the opposite manner if the stock goes down in price $1.

If you buy a 20 Delta Call on any stock (ETF) and the price of the security goes up $1 you will earn .20 cents x 100 or $20 on your option. If the stock moves up another $1 in price, the strike price you bought might now be a 25 Delta, which means you would earn another $25 for the second $1 increase. Let’s say you paid .75 cents ($75) for that 20 Delta and the security has now raised $2 in price. You would have made $20 on the first $1 rise and $25 on the second dollar rise. You have now made $75 on an option for which you originally paid $75. You now have a 100% ROI (Return on Investment) should you sell the option you bought.

Again, this works both ways, and had the security lost $2 in value you would have lost the $75 amount paid for the option (unless of course it turns back around and moves back up in price). When you buy an option you can only lose the amount paid for the option.

Selling options, on the other hand, opens one up to unlimited risk unless one limits risk by selling the trade as a spread (sell a call and buy a put simultaneously). If selling as a spread one can lose the amount of the spread minus the amount they received by selling the Call portion of the spread.

Let’s say you sell a $5 spread for $2.50 (risk = $500 - $250 received or $250 total risk). Since you received credit for the spread the goal would be to buy it back for less than what you received (i.e. buy the spread back for less than $2.50 received. If I sold a spread my goal would be to buy it back for a 50 – 75% profit (buy it back for less than 1.25). Selling options is not recommended for the inexperienced trader and selling options naked (not as a spread) is not recommended for any but the most experienced trader where poses a lot of risk for them as well.

An option is also subject to our friend called “Theta Decay.” This means that your Option Strike Price must outrun the price paid for the option.

To show how this works in real time I made two trades this morning as examples. These were on Friday May 24 Expiration for AMD and MSFT (which also provides time value for the trades, although they were both placed hoping to be in/out before the day is over).

At open I bought a 24 May MSFT 435 Delta 20 for .53 ($53) and resold it for $80 for a $27 profit (by the way I left money on the table since I was writing this at the same time and wished to show some profit.

For a second example I bought a 24 May AMD Delta .25 Put for .52 ($52) and just closed it for $88 or a $35 profit. Because I made those trades while writing this short essay on the Delta, I only traded one contract each when I would normally trade between 1-5+ contracts. So, as you can see, that was an easy $62 profit while trying to explain how Delta’s work. Had I traded 5 contracts on each stock there would have been a quick profit of $335. I only trade Delta’s this far out on Stocks that are volatile (AMD has a 14.2 Weekly ATR and MSFT a 14.3 ATR).

Hopefully this is helpful to some of you and comments/questions always appreciated.

Theta Decay is another subject involving “Intrinsic and Extrinsic Value” but we will save that for another discussion?

IN ANY EVENT THINK OF A DOLLAR BILL WHEN TRADING OPTIONS!

(Oh yes, and as a side note, I spend $3 every morning on a far out SPY Put just in case a Black Swan flies overhead before the day ends)
 
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