Over the past few months, I’ve shown you how I determine which stocks to trade options on, and how to select the options with the best chancing of doubling your money.

As you may recall, one of the keys to landing profits is finding the stock or exchange-traded fund (ETF) that’s about to break out to the upside or downside. Now, don’t get me wrong… You can make money off of stocks that are trading sideways. But as a directional, rules-based trader, I prefer the stocks and ETFs that are set to make explosive moves.

As important as this is, it’s even more important to make sure the options you’re trading will move in price, too.

And it all boils down to this “Greek” formula…

Let me show you what I mean…

Don’t worry, I’m not expecting you to sit down with a calculator, pen, and paper. Your broker (and software) will do that for you.

I’m showing this to you because it’s what’s used to calculate “Delta.”

Delta is one of the “Greeks” that comprise an option’s premium or value. It is considered by many to be the most important component of an option. Delta can be used in a couple different ways when you’re trading options. I’ll show you both of those and illustrate how paying attention to Delta can help you when determining which option to buy.

But first…

What is Delta?

In simple terms, Delta is a numerical value given to each option that shows how much that option’s premium will move with the next $1 move in the stock.

Deltas are either a positive number (for calls) or a negative number (for puts). Call options will have a value of anywhere from 0 to 1.00 where a put option has a value anywhere from -1.00 to 0.

Here’s a quick example: take a stock trading at $50, with a call option that has a Delta of .60. That means when the stock goes $1.00 higher, that call option should go up in price, on the Delta component alone, $0.60. On one contract, that means an increase of $60, since one contract = control of 100 shares.

With a put, take that same stock at $50. If you look at a put option that has a -0.60 Delta, that means when the stock drops in price by $1.00, the put option price, on the Delta component alone, should go up $0.60 or $60 per contract.

Mind you, the Delta will work against you by that same amount should the stock move against you. For example, if you have a call option with a 0.60 Delta and the stock drops $1.00, that call option should drop that 0.60, or $60 on the contract.

Two Ways to Use Delta

The first way to use Delta is to figure out how much you can expect the option price to move in relation to a $1.00 move up or down in the stock.

Here’s a quick example on Chewy, Inc. (CHWY)…

This CHWY option has a Delta of 92.76%, or 0.92. With an option premium of $2.55, how many 0.92 moves will it take to make another $2.55 and double your money? Just under three. So, using the Delta alone can help you plan for a roughly three-point move higher to get that double.

Options also have a time decay component to it called “Theta.” Another component is “Vega”, or the Implied Volatility factor, which we’ll talk about soon. Many things affect these factors and the pricing of options. Every day that goes by and every change in price of the underlying changes the dynamics of an option’s pricing.

Another thing to keep in mind is what’s called the “rate of change in delta,” which is represented by the Gamma. It shows how much Delta changes with each dollar move in the stock. If the gamma is 0.05, for example, that means the Delta should increase by $0.05 for every dollar move.

A positive Gamma, and a higher one at that, means the option could double faster than a six-point upwards price move in the stock.

The Delta will increase as the stock moves in your desired direction. The higher the Delta, the closer the option will track the stock.

Another Way to Look at Delta

The Delta value of an option plays a direct hand in determining that option’s profitability. An option’s moneyness – that is, whether it’s in-the money (ITM), at-the-money (ATM), or out-of-the-money (OTM) impacts the Delta value.

More specifically, the Delta tells you the probability that the option will end up ITM at expiration.

Here’s what I mean…

The highest Delta you can get on an option is 1.00. An option with a Delta of 1.00 is pretty much the closest thing you have to a 100% chance of the option ending up ITM.

At the Money (ATM) options typically have a Delta of .50, meaning it has a 50% chance of being ITM at expiration. Of course, that means there is a 50% chance it ends up Out of the Money (OTM) as well.

I feel if I start out ITM I should end up there, and the intent is to have it end up more ITM. If I start out on an option as close to .70 and it increases and goes closer to 1.00, my option should be increasing in price at an accelerated rate.

Why is this view on Delta important? If you start out with the purchase of an OTM option and say it has a Delta of 0.25 that means there is only a 25% chance this ends up ITM. When the option’s moneyness goes from OTM to ITM, that means the option should be increasing in value.

The option can go from OTM to ATM and the option should be increasing just on the Delta component, but it is not a guarantee.

On my straight directional options trades, I like to look for an ITM option with a higher Delta in the sweet spot of 0.70-0.75.

I want the underlying stock to move within 30 days. Because I need the stock to move quickly and I want to make a higher amount of money on each dollar move in my direction, the ITM options with the higher Delta pay out better than those that are OTM when things work. They also allow me to protect my capital because I am able to recoup more of my option premium in the event the stock trades flat.

Here’s your trading lesson summary:

An option’s Delta is one of its most important components. Here’s what it is, and why it’s important.

1. Delta is a numerical value that tells you how much an option’s premium will move with a move in the underlying stock. Delta can range from -1.0 to 1.0. -1.0 to 0 is the range for puts, while 0 to 1.0 is the range for calls.

2. You can use Delta to assess how much an option will move with each $1 move in the underlying stock. For example, a call option with a Delta of .50 indicates a $0.50 move in the option price for a $1 move in the stock.

3. You can also use Delta to assess an option’s profitability. For example, a call option with a Delta of 1.0 is almost assured to end up In the Money at expiration.

We’ll talk about another way the Greeks are vital to your trading success tomorrow…

Until then,

Tom Gentile

America’s Pattern Trader