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If you’ve read anything beyond this blog about options, you’ve seen a lot of references to “The Greeks.” These are names for five metrics that describe how options respond to various factors. They give option traders insights into the risk associated with a particular option. We first mentioned the Greek theta in an earlier post on extrinsic value. Theta describes how much an option’s value declines due to the passage of time. We’ve also alluded to the fact that changes in the price of the underlying have an even greater effect than time decay on an option’s value. The Greek delta quantifies how much impact price change will affect the price of an option. It answers the question “How much will the price of an option change if the underlying’s price changes by one dollar.” The image below shows the option chain for Amazon’s calls and puts expiring on September 9, 2022. The yellow shaded areas are ITM options, the unshaded areas are OTM. The strike level that is closest to the underlying price is at the money (ATM). An interesting feature of delta is that it can be a proxy for the chances of an option to expire ITM. Notice that the ATM options have deltas of .50, a value that represents the 50/50 possibility that the underlying will be above or below its current pricing at expiration. Delta can also be helpful in hedging, a topic we will address in future posts.
I use the delta as part of my process in selecting options. I like to deal with options that have high probability of expiring profitably. So if I’m bullish, I might sell a put with a delta around -.25. Remember that when you sell a put, you receive a credit. If this short put expires OTM, the option will expire worthless and you will pocket the credit received. The image below shows the profile for a bull put spread based on the 123 strike. You should understand that the purchase of the 122 strike was a hedge to limit the risk of the short put.
We’ll have more Greeks to discuss in later posts.
Key take-away: Delta is a metric that provides valuable insights for selecting trades.
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