Options Delta & IV Implied Volatility
For those who do not know, the Greeks are nothing more than a couple of metrics/numbers that are used to price and gauge the risk profile an option. Don’t be intimidated by them. For my style of trading, I am primarily concerned with Delta & the Impact that Implied Volatility has on it.
Delta is one of four major risk measures used by option traders. Delta measures the degree to which an option is exposed to shifts in the price of the underlying asset (i.e. stock) or commodity (i.e. futures contract). Values range from 1.0 to –1.0 (or 100 to –100, depending on the convention employed). For example, if you buy a call or a put option that is just out of the money (i.e. the strike price of the option is above the price of the underlying if the option is a call, and below the price of the underlying if the option is a put), then the option will always have a delta value that is somewhere between 1.0 and –1.0. Generally speaking, an at-the-money option usually has a delta at approximately 0.5 or -0.5.
As the option gets further in the money, delta approaches 1.00 on a call and –1.00 on a put. At these extremes there is a near or actual one-for-one relationship between changes in the price of the underlying and subsequent changes in the option price. In effect, at delta values of –1.00 and 1.00, the option mirrors the underlying in terms of price changes.
Implied volatility: Is a forecast of the underlying stock’s volatility as implied by the option’s price in the marketplace. As volatility rises, the time value of an option goes up and causes the delta of out-of-the-money options to increase and the delta of in-the-money options to decrease.
*Implied volatility (IV) is one of the most important concepts for options traders for two reasons. First, it shows how volatile the market might be in the future. Second, implied volatility can help you calculate probability. This is a critical component of options trading which may be helpful when trying to determine the likelihood of a stock reaching a specific price by a certain time. Keep in mind that while these reasons may assist you when making trading decisions, implied volatility does not provide a forecast with respect to market direction. Since most option trading volume usually occurs in at-the-money (ATM) options, these are the contracts generally used to calculate IV. When you understand the way the most heavily traded options (the ATM strikes) tend to be priced, you can readily see the validity of this approach. If the options are liquid then the model does not usually determine the prices of the ATM options; instead, supply and demand become the driving forces. Many times market makers will stop using a model because its values cannot keep up with the changes in these forces fast enough. When asked, What is your market for this option? the market maker may reply What are you willing to pay? This means all the transactions in these heavily traded options are what is setting the option’s price. Starting from this real-world pricing action, then, we can derive the implied volatility using an options pricing model. Hence it is not the market markers setting the price or implied volatility; it’s actual order flow. Implied volatility shows the market’s opinion of the stock’s potential moves, but it doesn’t forecast direction. To option traders, implied volatility is more important than historical volatility because IV factors in all market expectations. If, for example, the company plans to announce earnings or expects a major court ruling, these events will affect the implied volatility of options that expire that same month. Implied volatility helps you gauge how much of an impact news may have on the underlying stock.
*IV info Cortesy of ally.com
As an example lets take TSLA AUG 350.00 calls and the Delta is currently .35. This means, in theory, that for every 1.00 move in TSLA, the contract should move by .35 cents. Keep in mind that time decay will also have an impact on how the option contract responds to movement in the stock price. But for this example, we will assume that only the Delta is important.
Knowing that the Delta is .35, let’s assume that support is at 315.25 and do some #MATH so we can get to that ever so important stop on an Option trade. Here it is step by step Using hypothetical numbers.
1: Find out where the significant support level is on the underlying stock you are trading (these are the STOPS) I Post on my Watchlist then select an Option contract (this is the option(s) I post on the Watchlist or in my live Twitter Feed). We said the support level on TSLA was 315.25 and I decided we were trading the AUG 350.00 Calls which cost 9.00 (all hypothetical numbers for illustration).
2: Find out what the Delta is for the option contract being traded. In this example Delta is .35 Delta can be found on the option program on your trading platform.
3: Subtract the price at the support level from the current stock price. (325.00 – 315.25 = 9.75)
4: Multiply the Delta by the result that you got from the subtraction in step 3. (9.75 x .35= 3.41)
5: Subtract the result in step 4 above from the current option contract price. (9.00 -3.41= 5.58)
6: The result of the Subtraction in Step 5 above is where your stop loss on the Option Contract should be set. That’s your New Found Option Stop.
7: Try this calculation using one of your own trades by Plugging them into the Position Sizing Calculator on the Trading Template
By using the movement of the underlying stock and the Delta value of the option contract, you put yourself in a better position to manage the trade as opposed to just setting a random % risk level on the Option.
Once again this method is not for everyone and works best for larger accounts and swing trading or longer term options at least 1 week minimum expiration holding period and it works best in strong trending markets. Let me repeat: this method will work much better if you are buying calls in a strong upward trend or puts in a strong downward trend.
- Delta tends to increase as you get closer to expiration for near or at-the-money options and
- Delta is subject to change given changes in implied volatility.
- If you are long a call or a put (that is, you purchased them to open these positions), then the put will be delta negative and the call delta positive
These are the Greek Gods in the Option World and each has its own measure of risk summarized below.
Measures the impact of a change in volatility.
Measures the impact of a change in time remaining.
Measures the impact of a change in the price of underlying.
Measures the rate of change of delta.