In the past few months, I’ve show you how I determine which stocks to trade options on and how to select which options have the best chance at giving you a 100% return.
As I told you, finding a stock that’s going to make a move is key. Stocks that trade sideways are fine for non-directional trades, but I’m a directional trader. I like to predict which way a stock will move, and by how much, then start trading options accordingly.
As important as it is to find a stock that moves, it’s even more important to make sure that your option is going to move when the stock does.
So how can you find out ahead of time if your options are going to make a move in price? There’s only one number you need to know.
Let me show you what I mean…
All you have to do to find the one number that will tell you how an option will move is master this formula:
C = Value of the call option
St = Current value of underlying asset
N(d1) = Rate of change of the option price with respect to the price of the underlying asset
T = Option life as a percentage of year
ln = Natural log of
Rf = Risk-free rate of return
Simple, right? Luckily, your broker will do all that for you. Here’s what you need to know…
This formula is used to calculate “delta.”
Delta is one of the options “Greeks” that comprise an option’s premium or value. It is considered by many to be the most important component of an option.
Delta can be used in a couple of different ways when you’re trading options. I’ll show you both of those and illustrate how paying attention to delta can help you when determining which option to buy.
What Is Delta?
In simple terms, delta is a numerical value given to each option that shows how much that option’s premium will move with the next $1 move in the stock.
Deltas are either a positive number (for calls) or a negative number (for puts). Call options will have a value of anywhere from 0 to 1.00, while a put option has a value anywhere from -1.00 to 0.
Here’s a quick example: take a stock trading at $50 with a call option that has a delta of .60. That means when the stock goes $1.00 higher, that call option should go up $0.60 in price on the delta component alone. On one contract, that means an increase of $60, since one contract grants control of 100 shares.
With a put, take that same stock at $50. If you look at a put option that has a -0.60 delta, that means when the stock drops in price by $1.00, the put option price, on the delta component alone, should go up $0.60, or $60 per contract.
Mind you, the delta will work against you by that same amount should the stock move against you. For example, if you have a call option with a 0.60 delta and the stock drops $1.00, that call option should drop that 0.60, or $60 on the contract.
Two Ways to Use Delta When Trading Options
The first way to use delta is to figure out how much you can expect the option price to move in relation to a $1.00 move up or down in the stock.
Here’s a quick example using Monsanto Co. (NYSE: MON) at a closing stock price of $90.83 on Oct. 19, 2015.
These MON options have a delta of 61.06%, or .61. The option premium is $3.65, so how many .61 moves will it take to make another $3.65 and double your money? Roughly six. So just off the delta alone, you can guestimate a six-point move higher should get a double on the option, right?
If only it were that simple!
As we’ve talked about before, options have a time decay component called theta. Another component is vega, or the implied volatility factor. Many things affect these factors and the pricing of options. Each day that goes by and each change in the price of the underlying changes the dynamics of how an option is priced.
Another thing to keep in mind is the rate of change in the delta, which is represented by the gamma. It shows how much the delta number changes with each dollar move in the stock. If the gamma is 0.05, that means the delta should increase by $0.05 for every dollar move.
A positive gamma, and a higher one at that, means the option could double faster than a six-point upwards price move in the stock.
The delta will increase as the stock moves in your desired direction. The higher the delta, the closer the option will track the stock.
Another Way to Look at Delta
The delta value of an option plays a direct hand in determining that option’s profitability. An option’s “moneyness” (that is, whether it’s in the money, at the money, or out of the money) directly impacts the delta value.
More specifically, the delta tells you the probability of the option ending up in the money (ITM) at expiration.
Here’s what I mean…
The highest delta you can get on an option is 1.00. An option with a delta of 1.00 is pretty much the closest thing you have to a 100% chance of the option ending up ITM.
At the money (ATM) options typically have a delta of .50, meaning it has a 50% chance of being ITM at expiration. Of course, that means there is a 50% chance it ends up out of the money (OTM) as well.
I feel if I start out ITM, I should end up there, and the intent is to have it end up more ITM. If I start out on an option as close to .70 and it increases and goes closer to 1.00, my option should be increasing in price at an accelerated rate.
Why is this view on delta important? If you start out with the purchase of an OTM option and say it has a delta of .25, that means there is only a 25% chance this ends up ITM. When the option’s “moneyness” goes from OTM to ITM, that means the option should be increasing in value.
The option can go from OTM to ATM, and the option should be increasing just on the delta component, but it is not a guarantee.
On my straight directional options trades, I like to look for an ITM option with a higher delta in the sweet spot of .70 to .75.
I want the underlying stock to move within 30 days. Because I need the stock to move quickly, and I want to make a higher amount of money on each dollar move in my direction, the ITM options with the higher delta pay out better than those that are OTM when things work. They also allow me to protect my capital because I am able to recoup more of my option premium in the event the stock trades flat.
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