Delta definition

What is delta in trading?

Delta is a measure used in options trading to assess how the price of an options contract changes as the price of the underlying asset moves. It can also sometimes be referred to as a hedge ratio.

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Delta is representative of a change in the price of an options contract given a one-point change in the underlying asset.

Delta can be either shown as a negative or a positive figure, depending on whether the option is a put or a call. This is because a put option will have a price that moves inversely to the price of its underlying asset – resulting in a negative delta – while a call option will have a price that moves in correlation with the price of its underlying asset, giving a positive delta.

What are the Greeks?

The Greeks are different classifications of risk on the options market. Delta is one of a number of Greeks – the others being:

  • Gamma. This is how much an option’s delta moves for each point of movement in the underlying market
  • Theta. This is how much an option’s price declines over time – otherwise known as time decay
  • Vega. This is how responsive the price of an option is to any volatility changes in the underlying asset
  • Rho. This is how susceptible an option’s price is to any shifts in interest rates

When do traders use delta?

Traders use delta as an indicator of risk when trading options contracts. This is because it can show whether an options contract will expire in-the-money or out-of-the-money by tracking the price of the underlying relative to the price of the options contract itself.

A delta of one shows that the option will mirror the price changes of its underlying asset exactly, meaning a $1 increase or decrease in the underlying constitutes a $1 increase or decrease in the price of the option.

As a result, a delta of 0.75 on a call option means that a $1 increase in the price of the underlying constitutes a $0.75 increase in the call option.

Alternatively, a -0.25 delta on a put option would mean that the price of the put option would decrease by $0.25 for every $1 increase in the price of the underlying.

Delta example

Let’s assume that you currently hold 100 shares in company XYZ. You decide to hedge yourself against any adverse price movements in the underlying market by taking out a call option with a delta of -0.50.

So, a $1 decrease in the price of company XYZ’s shares will cause the price of the put option to increase by $0.50. This is because the price of a put option’s delta moves inversely to the price of the underlying asset. As a result, if the price of company XYZ decreased from $20 per share to $19 per share, the put option would be worth $0.50 more per share – partially offsetting the loss to your shareholdings.

If, on the other hand, you had a short position on company XYZ, you could use call options to hedge your position. If you held a call option with a delta of 0.50 on company XYZ stock, then a $1 increase in the price of company XYZ’s shares will make the call option worth $0.50 more. Let’s say that company XYZ’s shares currently traded at £20 each. If the share price increased to $21 and the cost of the call option was $1, then the price of the call option will increase by $0.50 per share.

To fully hedge their position, a trader would attempt to reach a delta-neutral state, where the option’s price movements are perfectly balanced in relation to the price movements of the underlying asset. To achieve a delta-neutral trade, an individual would take multiple positions until the delta effectively mirrored the price movements of the underlying.

However, delta-neutral trading strategies are only advised for advanced traders due to the constant monitoring required to make the strategy effective.

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