Understanding delta: A key metric for option traders

Delta is a number that ranges between 0 and 1. What does a call option which has a delta of 0.4 imply? Delta measures the rate of change of premium for every unit change in the underlying. So, a delta of 0.4 indicates that for every 1-point change in the underlying, the premium is likely change by 0.4 units, or for every 100 point change in the underlying the premium is likely to change by 40 points.

Let us understand it better with an example.

Nifty at 9:15 AM is at 18790

Option Strike 18750 Call Option

Premium = 144

Delta of the option = + 0.40

Nifty at 3:15 PM is expected to reach 18860

What is the likely option premium value at 3:15 PM?

As the Delta of the option is 0.40, which means for every 1-point change in the underlying the premium is expected to change by 0.40 points.

We are expecting the underlying to change by 70 points (18790 – 18860), hence the premium is supposed to increase by 70*0.40 = 28

Therefore, the new option premium is expected to trade around 172 (144+28)

Let us pick another case – what if one anticipates a fall in Nifty? What will happen to the premium? Let us figure out.

Nifty at 9:15 AM is at 18790

Option Strike = 18750 Call Option

Premium = 130

Delta of the option = 0.4

Nifty at 3:15 PM is expected to reach 18700

What is the likely premium value at 3:15 PM?

We are expecting Nifty to decline by – 90 points (18790 – 18700), hence the change in premium will be – 90 * 0.40 = – 36

Therefore, the premium is expected to trade at 130 – 36 = 94 (new premium value)

From the above two examples we observe the delta helps us evaluate the premium value based on the directional move in the underlying. This is extremely useful information to have while trading options. For example, assume you expect a massive 100 point up move on Nifty, and based on this expectation you decide to buy an option. There are two Call options, and you need to decide which one to buy.

Call Option 1 has a delta of 0.05

Call Option 2 has a delta of 0.2

So which option will you buy?

Let us calculate.

Change in underlying = 100 points

Call option 1 Delta = 0.05

Change in premium for call option 1 = 100*0.05 = 5

Call option 2 Delta = 0.2

Change in premium for call option 2 = 100*0.2 = 20

As we can see the same 100 point move in the underlying has different effects on different options. In this case clearly the trader would be better off buying Call Option 2. Thus, delta helps you select the right option strike to trade.

(The author is a homemaker, who dabbles in stock market investments in free time)