Delta is another key member of the option Greeks you need to understand if you are interested to trade in the derivatives market. The option premium price is highly sensitive towards to various factors, hence you need to understand the quantum and intensity of this sensitivity so that you can choose the right option contract to trade with the right strategy.
Just like other members Gamma, Theta, and Vega,Delta also helps to measure the risk in options trading. This can be a powerful tool to manage the risk in options trading and help you enter into the right trading strategy. Let's find out what Delta is, how it works and how you can use in options trading with delta-neutral option trading strategies.
What is Delta in Option Trading?
In simple words, Delta is the measurement tool with the value that shows how much an option price is sensitive towards change in the price of the underlying security or market. A delta in options represents how much an option value can fluctuate against the 1-point change in the original price of the underlying security or towards the market index.
Understanding Delta in Options Trading
Delta is one of the key variables in options trading used by traders as a tool for directional risk. The Delta helps the option buyers and sellers to determine how the premium of an option can be changed if the prices of the underlying security get changed.
Also Read: How to Manage or Do Risk Management in Options Trading
You can find the value of Delta on the stock exchange while checking the trade summary details, and it is calculated on a real-time basis through a computer algorithm. The Delta value can be positive or negative according to the type of options. It works for different types of options (Put or Call) as per the value of delta and option trading strategy used by the traders.
How Delta Works in Options?
The value of Delta can be in the range of 0 to 1 for call options and -1 to 0 for put options.If Delta value is 0.25, it means the option premium price will change by 25% for every 1-point change in the price of the underlying security. On the other hand, if the Delta value of the put option is -0.25, it means the price of an option premium will decrease by 25% on every 1-point change.
For the call option positive Delta works, while for the put option Delta value is represented as negative. It plays a significant role in determining the price of an option premium. The Delta with a negative for put option means price movement will be inverse of an underlying security and this kind of behaviour of Delta tends to encourage short-selling among the investors.
How to Use Delta in Options Trading?
Traders use the Delta not only to measure the sensitivity level of option premium against the original price of the underlying security but also to determine the price of the option premium. However, there are various points where you can use the Delta in option trading. Let's find out how you can use the Delta in an option trading strategy.
For Position Sizing
Delta in options will help you in determining the right number of contracts to buy or sell as per your risk tolerance and exposure to the market. Hence, as per the value of Delta, you can resize your positions, like higher the value of Delta you can choose the right contract.
If you are a high-risk trader, you can choose to trade the options with high Delta value, while the trader looking to trade with low-risk exposure can choose the Delta with low value. Based on the market conditions and the value of delta you can use the positing sizing strategy in option trading, which will help you to curb the potential effects of unexpected market conditions.
Hedging the Portfolio
Apart from positing sizing, you can also use the Delta to hedge your portfolio against various investments. In Delta hedging you can offset your positions in the underlying security to minimize the impact of risk associated with movement of the price.
Using the Delta values of an option contract you can hedge against the potential downside risk by incorporating the options with different values (positive and negative) Delta. Using the Delta for hedging will harmonize the entire Delta of your portfolio.
Delta for Direction-based Trading
If you expect the price of the underlying security to move in a particular direction, you can use the delta to choose the right options as per your desired sensitivity. Yes, you can use the Delta value for directional trading, like Delta with positive values will leverage the rise in the price of an underlying security.
While the Delta with negative values will help you to choose the option you expect will decrease with the decrease in the price of the underlying security. However, with a more in-depth analysis of Delta how your portfolio is exposed to change in the direction of the market.
To Optimize Your Portfolio
The value of Delta is also useful in optimizing the overall delta of your portfolio. You can check the delta of your entire portfolio and adjust the desired level of exposure to the market to create a delta-neutral portfolio that is not affected by significant price movement.
Suppose you long a call with the Delta value of +0.25 and two calls with +0.15 Delta, then your Delta of your total option portfolio would be +0.55. Here, you have to buy put with a delta value of -0.55 to make your portfolio with Delta neutral.
Delta Neutral Options Strategy
The Delta neutral option means when there are changes in the market your portfolio with Delta neutral will be not affected that much. Here you can hold the combination of calls and puts with different Delta values so that fluctuation in different options doesn't have a major impact on the entire portfolio as it is in the neutral position.
Delta neutral options strategy is used by the traders to minimize the effect of the price change while taking advantage of price change due to implied volatility that occurs with the time decay of the options. Traders buy securities that are in reverserelation to their original position. If there is any inverse price, relation the underlying security will move in the reverse direction.
Also Read: How to Use Implied Volatility in Options Trading: Strategies
Delta Neutral Hedging Strategy
In option trading, the traders hedge their options portfolio to generate income while reducing the risk from unexpected movement in the price of the underlying security. This strategy is used to construct the portfolio with long and short options in the underlying security in such a manner the Delta of the portfolio becomes zero or you can say neutral.
This kind of hedging-based Delta neutral strategy makes your portfolio not exposed to changes in the price of the underlying security. To follow this strategy you have to keep adjusting your positions to maintain neutrality in the Delta of your portfolio. The rebalancing can be done daily, weekly or monthly as per the market condition and your trading strategy.
Delta Neutral Strategy Example
As in the delta-neutral strategy, you have to introduce a positive Delta by entering into the long positions of the underlying security to balance the negative delta of the long put. This adjustment will make the Delta neutral position where gains or losses from the directional price change are mostly offset preventing the position from unexpected movements.
Also Read: Why People Lose Money in Option Trading: Reasons & How to Avoid
In such hedged positions, if the price of the underlying security declines most of the gains from the long put with a negative Delta, will be offset by the corresponding loss in the securities purchased with a positive delta. To make it clear let's take an example.
Suppose, you bought 100 contracts of put options of an underlying security (ABC) with the delta of -0.20. Here the delta of the entire contract position is -0.20x100x100= -2000, which means your option position has a negative delta with the directional exposure.
Also Read: How to Recover Loss in Option Trading: Tips to Avoid Losses
Here, to make your option position a Delta neutral hedging strategy you have to buy the 100 shares of the ABC underlying security with the positive delta to offset the negative delta from the puts. By doing this, your position becomes delta-neutral allowing you to enjoy the gains from the changes in the implied volatility while minimizing the impact of stock price movement.
When to Use Delta Neutral Strategy?
You can use the Delta in option strategy to neutralize the risk exposure of your short-term investment in the options. The Delta neutral strategy is one of the best ones you can use to protect your options from the fluctuation of price from positive and negative Delta.
This strategy can be used when you expect the market or underlying security price will remain volatile for upcoming days, but are not sure about the direction. However, below you can find the various situations where you can use the Delta neutral strategies.
Also Read: How to Trade in High Volatile Market: Best Trading Strategies
Uncertainty in the Market: When the market is uncertain, means there is ambiguity in the market during unstable economic conditions or big political events you should use the delta neutral strategies to prevent your investments.
Event-Based Volatility: If you expect an upcoming event like new services or product introduction, major corporate actions or regulatory actions can make the underlying security highly volatile. In such situations, you can choose to trade with Delta's neutral strategy.
Also Read: What Option Strategy is Best for High Volatility: 6 Strategies
Breakout or Breakdown: When you expect there is likely breakout or breakdown but are not sure in which direction can move, then Delta's neutral strategy can help you. In such an indecisive situation Delta, neutral positions can protect your abrupt price movement.
Financial Results: When companies declare their quarterly financial results, the stock price of the company becomes volatile, or can move in either direction. And if you are looking to trade in the option of such stock choose the Delta neutral strategy to take advantage ofsuch unexpected swings.
Summing-up
Delta can tell you how the premium of an option contract is sensitive towards the price change of an underlying security. The delta value can be positive or negative and based on these Delta values you can choose the call options or put options. Usually, options with a positive Delta are used for the call and a negative delta is used for a put option.
Also Read: What is Put Call Ratio & How to Use it for Options Trading
The call delta range can be between 0 to 1, while for put options delta range remains between 0 to -1. You can use the Delta in options with various strategies like position sizing, hedging your portfolio and direction-based trading to optimize your portfolio.
Also Read: How to Choose the Right Option Strategy in Algo Trading
The best way to use this member of Option Greeks is to trade with Delta neutral strategy to minimize the impact of positive and negative delta underlying securities on your portfolio to get a balanced return. And based on the market situation and price volatility of the underlying security you can choose the Delta neutral strategy to get well-adjusted returns.
Also Read: Algo or Manual Trading Which one is better for the Option Market
