Understanding Greeks – Delta

Delta is the easiest of the Greeks for most investors and traders to understand.  Delta is the expected profit per $1 move in the underlying.  If you are long a 40 Delta call, you expect to make $0.40 on a $1 rally in the underlying.  There are a number of ways that we can describe Delta in order to help visualize why it matters and can mean more than this to you:

  1. $ PnL/$ move in Underlying – as described above. Looking at the graph of the call payout, the Delta is the slope of the call payout curve.
  2. Hedge Ratio – the number of shares of the underlying one would have to sell to eliminate their directional exposure
  3. A Proxy for the Probability the Option finishes in-the-money

Let’s expand more on definitions 2 and 3, as they are a bit less obvious as ways to understand the Delta Greek.  If you are long one 40 Delta call, but wanted to have your options exposure limited to the Greeks other than Delta, you would sell 40 shares of the underlying.  Now, you are trading the other Greeks and not Delta.  This is what I did for years as a Volatility Trader – we did not trade a directional bias.  We traded based upon biases in the option-specific Greeks.

Definition 3 is one of my favorite ways to think of Delta because it’s not as commonly used and helps you understand what the market is telling you about your directional thesis.  If you think an equity has a 20% chance of rallying 40% over 2 months, but the call that would be slightly in-the-money in that scenario is a 5 Delta, then you have a mispricing between your directional thesis and the market.  This does NOT mean that you should buy that specific call, as there are traditionally much better structures that are more profitable in this trade scenario, but it does help to align your expectations with what the market is telling you can or should happen.

Delta is one of the most basic Greeks and is, for that reason, often skimmed over, but I believe it is very important to take that Delta and factor that into your trade construction.  I’ll continue to discuss Delta in many ways as we go through my commentaries, but this primer should give you some basic understand of Delta and how I look at it.

 

 

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