The Delta Effect: How to make money on even small mkt moves

If you are trading in options you may have heard of fortune stories of how traders double or triple their money by trading OTM option which happens because of delta acceleration. There are different delta stages. For understanding purpose I have assumed numerical values which are not real.

1. Predevelopment – This is the stage when the option is OTM or deep OTM. The delta here is close to 0. The delta will remain close to 0 even when the option moves from deep OTM to OTM. For example, when spot is 19400, 19700 Call Option is Deep OTM, which is likely to have a delta of 0.05. Now even if the spot moves from 19400 to let us say 19500, the delta of 19700 Call option will not move much as 19700 CE is still an OTM option. The delta will still be a small non-zero number.

So, if the premium for 19700 CE when spot is at 19400 is Rs 12, then when Nifty moves to 19500 (100 point move) the premium is likely to move by 100*0.05 = 5 points.

Hence the new premium will be Rs 12+5 = Rs 17. However, the 19700 CE is now considered slightly OTM and not really deep OTM.

The change in premium value in absolute terms maybe small (Rs 5), but in percentage terms the Rs 12 option has changed by approximately 41 per cent to Rs 17.

So, Deep OTM options moves by an impressive percentage however for this to happen the spot has to move by a large value.

Suggestion – avoid buying deep OTM options because the deltas are really small and the underlying has to move massively for the option to work in your favor.

2. Take off & Acceleration – This is the stage when the option moves from OTM to ATM. This is where there is scope for huge profit.

Consider this – Nifty spot @ 19400, strike is 19500 CE, option is slightly OTM, delta is 0.25, premium is Rs 20.

Spot moves from 19400 to 19500 (100 points), to figure out what happens on the premium side, let us do some math –

Change in underlying = 100

Delta for 19500 CE = 0.25

Premium change = 100*0.25 = 25

New premium = Rs 20 + 25 = Rs 45

Percentage change = 125 per cent

For the same 100 point move slightly OTM options behaves very differently.

So, the slightly OTM option which usually has a delta value of say 0.2 or 0.3 is more sensitive to changes in the underlying. For any meaningful change in the underlying the percentage change in the slightly OTM options is very impressive. In fact, this is exactly how option traders double or triple their money i.e. by buying slightly OTM options when they expect big moves in the underlying.

Suggestion – Buying slightly OTM option is more expensive than buying deep OTM options, but if your view is right you stand to make a fortune. Whenever you buy options, consider buying slightly OTM options.

Now let us observe how the ATM option would react for the same 100 point move.

Spot = 19400

Strike = 19400 (ATM)

Premium = Rs 70

Change in underlying = 100

Delta for 19400 CE = 0.5

Premium change = 100*0.5 = 50

New premium = Rs 70 + 50 = Rs 120

Percentage change = 83 per cent

So, ATM options are more sensitive to changes in the spot when compared to OTM options. Now because the ATM’s delta is high the underlying need not really move by a large value. Even if the underlying moves by a small value the option premium changes. However, buying ATM options are more expensive when compared to OTM options.

Suggestion – Buy ATM options when you want to play safe. The ATM option will move even if the underlying does not move by a large value.

3. Stabilization – When the option moves from ATM to ITM and Deep ITM the delta starts to stabilize at 1. The delta starts to flatten out when it hits the value of 1. This means the option can be ITM or deep ITM but the delta gets fixed to 1 and would not change in value.

Let us see how this works:

Nifty Spot = 19400

Option 1 = 19300 CE strike, ITM option, Delta of 0.8, and premium is Rs 105

Option 2 = 19200 CE strike, Deep ITM Option, Delta of 1.0, and premium is Rs 210

Change in underlying = 100 points, hence Nifty moves to 19500. Given this let us see how the two options behave –

Change in premium for Option 1 = 100*0.8 = 80

New premium for Option 1 = Rs 105 + 80 = Rs 185

Percentage change = 80/105 = 76.19%

Change in premium for Option 2 = 100*1 = 100

New premium for Option 2 = Rs 210+100 = Rs 310

Percentage change = 100/210 = 47.6%

In terms of the absolute change in the number of points, the deep ITM option scores over the slightly ITM option. However, in terms of percentage change, it is the other way round. Clearly ITM options are more sensitive to the changes in the underlying, but certainly most expensive.

Most importantly notice the change in the deep ITM option (delta 1) for a change of 100 points in the underlying there is a change of 100 points in the option premium. This means to say when you buy a deep ITM option it is as good as buying the underlying itself. This is because whatever is the change in the underlying, the deep ITM option will experience the same change.

Suggestion – Buy the ITM options when you want to play very safe. The ITM options have a high delta, which means they are most sensitive to changes in the underlying.

Deep ITM option moves in line with the underlying, this means you can substitute a deep ITM option to a futures contract. So, the point is, both futures and Deep ITM options react very similar to the changes in the underlying. Hence you are better off buying a Deep ITM option and therefore lessen your margin burden.

As the option transitions from OTM to ATM to ITM, so does the delta. Below are the inferences drawn:

• Delta hits a value of 0.5 for ATM options

• Delta predevelopment is when the option transitions from Deep OTM to OTM

• Delta take off and acceleration is when the option transitions from OTM to ATM

• Delta stabilization is when the option transitions from ATM to ITM to Deep ITM

• Buying options in the take off stage tends to give high percentage return

• Buying Deep ITM option is as good as buying the underlying.

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