Know your Delta (part 3)
So to continue from part one and two where I said in part 1: Delta is a measure on how the price of an option may vary in relation to the change in the price of a stock. Delta can vary between 1.0 and -1.0 (sometimes expressed as 100% or -100%).
In part 2, I showed an example (CBA, price $78.49 – May 2014): The option is out-of-money. The Strike price is 80.09 and therefore above the underlying stock price. We call this strike out of the money. Delta is less than 0.5. In this case, 0.272
If the price is below 78.49, we call that strike in the money and Delta will be higher than 50% (or 0.5). The further away from the underlying price, the higher delta is.
IN this Part 3
The option is in-the-money. Delta is more than 0.5. In this case, 0.904.
Once again we must say that Delta is mathematically imprecise but is used nonetheless as a general rule of thumb by option traders. A trader would say the delta is a statistical approximation of the likelihood of the option expiring in-the-money. An option with a 0.75 delta would have a 75 percent chance of being in-the-money at expiration under this definition. An option with a 0.20 delta would be thought of having a 20 percent chance of expiring in-the-money (Trade Option Greeks, D. Passarelli, 2012).
Delta can be used to create a delta-neutral position. Delta neutral trading is the construction of positions that do not react to small changes in the price of the underlying stock. No matter if the underlying stock goes up or down, the position maintains its value and neither increases nor decreases in price. To determine how many contacts of you need to buy or sell, you should divide a number of shares on delta and then divide on 100 (number of shares in one contract).