Delta is a ratio which measures the degree of correlation between changes in price for the underlying security and changes in the price of the option. Put another way, Delta indicates the amount of price change in a derivative by comparing changes between asset and derivative prices.
Delta is a multiple that applies to options positions; it, along with Gamma, Theta, and Vega, helps options investors calculate risk and potential return for an investment. Delta can quickly tell an options investor how much the price of their option will change per share relative to the price change in the underlying security. Delta is represented by a number between 1 and -1, with a negative Delta value sometimes written in accounting notation, like: (1).
A call – a type of contract that allows the holder of the contract to purchase an underlying stock at a specific price, even if the market price goes higher – will have a positive delta. A put option – which gives the owner the right to sell a stock at the strike price names in the contract – will have a negative delta. For example, if a call option has a delta of .5, and the underlying security has a price change of $5 per share, the option price would increase by $2.50. Inversely, if a put option has a delta of (.5), a $1 increase in share price will mean a $0.50 decrease in the price of the put option.
Options contracts contain 100 options, so the real gains and losses for the contract would be multiplied by 100. Delta can be added up for a trader's entire portfolio of options and tied to a major index, such as SPY, to get an idea of how the investor will fare if the market as a whole moves one way or the other.
Delta can also be weighted for beta and other factors. If a trader would prefer to not be exposed to much delta and could maintain the value of his investments even while owning options, he would attempt to achieve this through delta hedging.
Delta hedging is the process of reducing exposure to potential loss resulting from price fluctuations in the security underlying his or her options positions by bringing the delta of a portfolio to zero, or closer to it (a position called ‘delta neutral’ or ‘delta hedged’). This is accomplished by purchasing financial instruments which counterbalance each other's exposure to price fluctuations, often adding short or long positions in other options or the underlying securities themselves.
The quantity of each security that the investor would need to buy (or sell short) to achieve the desired hedging effect would be determined using the delta number of each position involved. The closer the total delta gets to zero, the more delta neutral or delta hedged the investor is.
An example: a put option will lose value while the underlying security increases in value. To hedge against this, an investor could purchase more of the underlying security. The exact quantity is determined by the delta and the number of options owned.
If you own a put option contract with 100 put options in it, and you have a delta of (.2), you would need to buy 20 shares of the underlying security to completely offset your negative exposure to price increases, which would be called delta neutral, and Delta would equal zero.
Delta helps traders gauge risk and return on an investment and buy or sell accordingly. Because call or put option Delta behave predictably, they are useful to many different types of investors.
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