Lots of option traders buy calls hoping to profit from a bullish move in a stock. It is a leveraged trade that can create huge percentage profits when the trader is right and, of course, potentially pretty big percentage losses when wrong. But when option traders get used to seeing these big p&(L) swings from long calls they are sometimes surprised (either pleasantly or unpleasantly) by the size of the gain or loss. That’s why I ALWAYS look at the option delta of my trades.
Delta is the rate of change of an option’s price relative to a change in the underlying security. Option deltas are stated in percentage terms. So if an option has a “50 delta” (sometimes stated as a “.50 delta”) it will move 50 percent as much as the underlying stock.
For example, lets say a trader buys 10 December 50 call options which have a 35 delta. That means if the stock rises by $1 a share, the trader would anticipate gaining $350 as a result of the option’s delta. Why? each call would change in value 35 percent of the change in the stock. In this case, the stock gained $1, so each call would gain 35 cents (or $35 of actual cash). Because the trader owns 10 calls, that’s a $350 profit. And remember, it works both ways. If the stock would have fallen, it would have cost the trader a $350 loss.
Effectively, an option delta is a measure of trading leverage. If the stock moves by X, what do I make? It is important for a trader to know the option’s delta on every trade so he understands his trading exposure.
For more option trading education, download a free excerpt from my book here. This is an excerpt from chapter 6 of Trading Option Greeks, which discusses put-call parity.