The Most Important Lesson for Options Traders

by Chris Rowe

I am not joking when I say that gaining an understanding of delta changed my trading life forever. And I promise that this four-part series will be one of the most important and influential investing lessons you've ever had.

Even if you don't trade options, you should still read this, because it can significantly reduce your risk in this market. You can learn how to replace your overpriced stock with call options -- but you MUST know which options to buy, or else you might actually increase your risk instead.

Learning about delta and using it to make better trades is not really complex, so don't be intimidated. Just remember the two most important things:

1) If you sell your stock and buy call options to replace it, then buy "in-the-money" call options.

2) Only buy one call option for every 100 shares of stock that you own (or would want to own).

In other words, if you have 100 shares of Capital One Financial (COF), and want to close the position at $21.60, you will have $2,160. To establish an option position, you should buy only one call option contract (which represents 100 shares). If you buy the COF Jan 15 Call and pay $8 per contract (an $800 investment), then you should put the remaining $1,360 in a safe, interest-bearing security, such as a money-market fund or Treasuries.

This four-part series will help you understand why it's important to buy in-the-money call options in place of stock (as opposed to at-the-money or out-of-the-money options).

What is Delta?

The "delta" of an option measures how much the option changes in price when the underlying security moves one point.

For example:

Let's say that ExxonMobil (XOM) is trading at $65 per share, and the XOM Jan 65 Call is selling for $5. (NOTE: Because XOM's stock price is the same as this option's strike price, this option is trading at-the-money.)

When XOM rises one point (from $65 to $66), the Jan 65 Call should then sell for $5.50. Thus, the option only increases by 50 cents when the stock rises by one full point. This at-the-money option is said to have a delta of 0.50.

Decoding the Delta

The delta of an option is a number that ranges from 0.00 to 1.00, and the delta of a put option is a number that ranges from -1.00 to 0.00. A call with a delta of 0.70 implies virtually the same thing as a put with a delta of -0.70.

You will notice that when a call option is far out-of-the-money (for example, the XOM Jan 95 Call is 30 points out-of-the-money), it will either move only slightly, or not move at all, when the stock rises by one point.

The delta of this far out-of-the-money call is only 0.04. So theoretically, if XOM moved up by one point, the price of the $95 calls should advance by 4 cents.

Now, that might seem like a lot in terms of the percentage gain since the theoretical value of this far out-of-the-money option is about 27 cents. (A 4-cent gain would be a 15% gain on a 27-cent call option). But you have to consider the fact that the spread between the bid and ask price can be much larger than the 4-cent gain in the option (so you can still end up with a losing position).

The rule of thumb here is the higher the delta is, the more likely it is the option ends up profitable.

Out-of-the-money options have the lowest delta, while in-the-money options have the highest delta. So you'd want to avoid the out-of-the-money option that has the delta of 0.04 like the plague.

On the other hand, if the stock is trading far above the call option's strike price -- or, said differently, the option is "deep in-the-money" (i.e., the XOM Jan 45 Call, which is 20 points in-the-money with the stock trading at $65), then the call option would likely have a delta of 0.96.

Thus, when the stock moves up one full point, the option will likely move up 96 cents. (Almost point-for-point, aka trading at "parity" with the stock.)

If a call option moved up one full point due to the underlying stock moving up one full point, then the option has a delta of 1.00, and so on.

A put option would work the same way whereas, if XOM moved down one point, a put option that has a delta of -0.70 would move up by 70 cents.