I often get asked why delta is such a big deal when trading options.
For those that don't know, delta is one of the Greek by-products of the option pricing model.
Over your head?
No worries. Let's break it down because delta really is a big deal and it can greatly improve your trading results if you know how to use it properly.
You see, options are an investment, just like stocks.
But with options, you can't just trade them in a vacuum and expect results.
The reason? Because an option's value is completely derived from other sources - it's the reason why it's called a "derivative" product.
And in order to understand an option's worth and how it will move, you first need to get a grip on its underlying security.
The underlying security is the stock (or commodity or bond) on which the option is based.
So, if you're going to trade Microsoft (MSFT) options, then you need to have an opinion about MSFT stock first. There's no sense in trading MSFT options if you have no thoughts on the stock.
All option prices on MSFT are tied to the movements of MSFT stock, so it's best to know what your directional assessment is. MSFT options are derived from where MSFT stock trades. That's how it works.
Now, an option's value will fluctuate higher or lower depending on how the stock moves.
And once the stock starts to move, how much do you think the option should move?
Have you ever thought about that concept?
I know some novice traders think that the option will "just move" because the stock does.
Really? Don't be so sure.
Yes, in most cases, the option price will move, but do you know by how much?
Here's the secret:
Delta tells you how much the option price will move in conjunction with the stock's movement.
That's a very important concept, and not all deltas are created equal.
Deltas range from 0-100 (0% to 100%), and each individual option has its own delta.
So if an option has a delta of 50 (50%), then it's price will move roughly half of whatever the stock moves.
Why is that important?
Well, don't you want to buy an option that's going to move when the stock does?
It would seem like a "duh!" question, but most beginner option traders have no clue about it.
Let me show you something.
Above is an option chain for Microsoft using the June 19, 2020 expiration.
With MSFT stock at $167.10, I've circled two different call options with two very different option prices and deltas.
If you're bullish on MSFT, I bet at first glance, you'd probably choose the $185 call options because their price is much cheaper compared to the $145 call options.
I mean, who wouldn't want to spend $2.51 per contract (splitting the bid/ask) instead of $24.80 per contract (splitting the bid/ask).
In real dollars using the 100 share multiplier, that's $251 versus $2,480.
Of course most people would choose the $185 call because they're so much cheaper. It's a savings of roughly 90%.
But, is that really the best choice?
The deltas are vastly different: 22.61% versus 82.79%.
For every $1 move in MSFT, the $145 call options will move 82.79% of it and the $145 call will only move $22.61% of it.
Break-evens and Odds
Now, two of the other biggest factors that affect your potential profitability are how long you hold onto the option and how similar the option's breakeven price is to the stock's breakeven price.
If the stock doesn't move above the option's breakeven price by expiration, you will lose 100% of your investment. So it's intuitive to want the option's breakeven to be very close to the stock's breakeven to get the most bang for your buck.
In my almost 30 years of option trading experience and talking with many retail traders, most will opt to hold the trade until expiration. Why close the trade early when you've paid for months of opportunity. Right?
That could be your biggest downfall, but that's a conversation for another day.
As mentioned, one of the most critical aspects when buying call options is that you want to choose an option that closely mimics the stock (and has close to the same break-even as the stock).
How is that done? By picking an option with a very high delta.
By using a high delta option, you are assured of getting almost as much movement as the stock.
Don't be afraid of spending more on a high delta option.
Since option contracts consist of 100 shares of stock, let's look at the numbers.
100 shares of MSFT would cost $16,710.
1 contract of the $145 call options would cost $2,480.
1 contract of the $185 call options would cost $251.
The breakeven on the stock would be $167.10 (obviously!)
The breakeven on the $145 call option would be $169.80 ($145 strike + $24.80 price).
The breakeven on the $185 call option would be $187.51 ($185 strike + $2.51 price).
Look at how much closer the $145 calls are to the stock's breakeven compared to the $185 calls.
That's a big deal.
How about the P/L?
The big question is - why would you choose an option strike ($185 calls) that needs the stock to move another $20.41 from its current price in order to just breakeven (if held to expiration)?
That's such a big move. Are you sure MSFT could continue to move that far in that amount of time?
Whereas, the $145 call options only needs the stock to move a mere $2.70 per share in order to breakeven. That's a much more palatable move.
This chart might help a bit too:
It's clear to see that the stock and the $145 calls are much closer in dollar profitability and breakeven levels than the $185 calls.
And with the deltas being 82% and 22% respectively, the $145 calls will get so much more movement in their price, and sooner, as compared to the $185.
When MSFT moves, you don't want to be disappointed to not see your option move ($185 calls).
I've heard from so many new option traders that they get disappointed that their call options don't gain any value even though the stock had large moves.
The reason is always the same - they choose low delta, out-of-the-money (OTM) options.
Don't fall for that trap.
Yes, the low delta options cost less, but they don't give bang for the buck.
And although the $145 call option cost $2,480 per contract, it's still $14,230 less than 100 shares of MSFT.
Don't be afraid to spend the money on high delta options. As long as the stock moves in your intended direction, you will be rewarded (and happy) with the results.
I've written a 30-page report which details a 3-year study on this exact strategy and how it can be used to piggyback one of the world's greatest investors.
Click here for more information.
That's all for this week.
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Until next time...