Delta is a measure of the change in an Option’s theoretical value given a $1 change in the underlying. It can used to approximate the price of the option as the stock moves by dollar, and you can set the limit and stop prices based on this information. Hence it is important to know the relationship between the Stock and the underlying option in terms of the price of the underlying asset.
A positive Delta can mean either that, when the stock value goes up, the option value will also go up, or that when the stock value goes down, the option value will also go down. On the other hand, a negative Delta can mean either that, when the stock value goes down, the option value will go up, or when the stock value goes up, the option value will go down. In short, a Positive Delta means that you are bullish and a Negative Delta means that you are bearish on a position.
• Long Stock Delta is 1.
• Long Calls have Positive Delta.
• Short Calls have Negative Delta.
• Long Puts have Negative Delta.
• Short Puts have Positive Delta.
Delta is a number between 0 and +/-1.00 that has a variety of different uses and interpretations such as Hedge Ratio, change in price of an option given as $1 change in the underlying stock and the probability that an option will finish in-the-money. The higher the Delta, the higher the probability that the option will expire ITM. Buying an Option with higher Delta, or selling an option with lower Delta, increases the Probability of Success.
Traders often use Delta as a stock equivalency for that option. Delta tells the trader how many shares to buy or sell, in order to establish the offsetting position, to create an overall delta neutral position, at that moment in time. Hedge ratio is important as it gives you a sense of how much exposure you have to the market and enable you to initiate negative delta positions in order to maintain a neutral market portfolio. See Table 28.
To build a market neutral portfolio or a slightly bullish portfolio, look at both the overall and individual deltas and decide whether to maximize exposure to the market by initiating positions with negative deltas, or minimize exposure to the market. As an example, let’s go through a scenario. Suppose XYZ is trading at $105 and May 105 Call Trading to 1.25, then the Delta is 0.48. Now if the Stock value for XYZ moves up by a dollar to $106, then the Delta value will $1.25+ $0.48 = $1.73.