Lesson: 7 Delta- Part 2 THINK LIKE MODEL

In the early Introduction article of Delta we talk of Basic understanding- Besides discussing the Delta, There are few more agenda will learn in this post. Let me explain what I mean to say will open up new evaluation options for trading perspectives. hopefully, will think of every possible dimensional rather than single.

For instance going forward if you have view on markets Bullish you may not strategics your trade this way – ‘My view is bullish, therefore it makes sense to either buy a call option or collect premium by selling a put option.

Rather you may strategics this way – My view is bullish as I expect the market to move by 40 points, i.e. 11050 to 11090 therefore it makes sense to buy an option which has a delta of 0.5 or more as the option i.e. 11050 Strike is expected to gain at least 20 points for the given 40 point move in the market”.

See the difference between the two thought processes? While the former is a casual, the latter is well defined and quantitative in nature. The expectation of a 20 point move in the option premium was an outcome of a formula that we explored in the previous chapter –

Expected change in option premium = Option Delta * Points change in underlying

This is just One piece of entire dish, As we move further and discuss more on other Greek letter it will become more Quantitative and selected more like Scientifically streamlined. It will provide scope of thinking forward and guided by equations and numbers will trading perspectives. I know there are many traders who trade just with a few random thoughts and some may even be successful. However this is not everybody’s cup of tea. The odds are better when you put numbers in perspective – and this happens when you develop a Model. So please do keep model framework in perspective while analyzing options, as this will help you setup systematic trades.

Delta versus spot price

In the previous chapter we looked at the significance of Delta and also understood how one can use delta to evaluate the expected change in premium. Before we proceed any further, here

Call options has a +ve delta. It range from 0 to 1. A call Option with Delta 0.5 indicate every 1 Point gain/loss in underlying the call option premium gain/loss 0.5 points.
Put options has a –ve delta. It range from -1 to 0. A Put option with a delta of -0.5 Indicates that for every 1 point loss/gain in the underlying the put option premium gains/losses 0.5 points
OTM options have a delta value between 0 and 0.5, ATM option has a delta of 0.5, and ITM option has a delta between 0.5 and 1.
Let discuss more for OTM Option to make clear view. Assume Nifty Spot is at 11160, strike under consideration is 11300, and option type is CE (Call option, European).
What is the approximate Delta value for the 11300 CE when the spot is 11160?
Delta should be between 0 and 0.5 as 11300 CE is OTM. Let us assume Delta is 0.4
Assume Nifty spot moves from 11160 to 11300, what do you think is the Delta value?
Delta should be around 0.5 as the 11300 CE is now an ATM option
Further assume Nifty spot moves from 11300 to 11500, what do you think is the Delta value?
Delta should be above 0.5 to 1 as the 11500 CE is now an ITM option. Let us say 0.8.
Finally assume Nifty Spot cracks heavily and drops back to 11100 from 11500, what happens to delta?
With the fall in spot, the option has again become an OTM from ITM, hence the value of delta also falls from 0.8 to let us say 0.30.
Clearly as and when the spot value changes, the moneyness of an option changes, and therefore the delta also changes.

Now this is a very important point here – the delta changes with changes in the value of spot. Hence delta is a variable and not really a fixed entity. Therefore if an option has a delta of 0.3, the value is likely to change with the change in the value of the underlying.

Have a look at the chart below – it captures the movement of delta versus the spot price. The chart is a generic one and not specific to any particular option or strike as such. As you can see there are two lines –

The blue line captures the behavior of the Call option’s delta (varies from 0 to 1)

The red line captures the behavior of the Put option’s delta (varies from -1 to 0)

The Delta Acceleration Stages:

Initial Stage 1– This is the stage when the option is OTM or deep OTM. The delta here is close to 0. The delta will remain close to 0 even when the option moves from deep OTM to OTM. For example when spot is 11150, 11700 Call Option is Deep OTM, which is likely to have a delta of 0.05. Now even if the spot moves from 11150 to let us say 11200, the delta of 11700 Call option will not move much as 11700 CE is still an OTM option. The delta will still be a small non – zero number.

So if the premium for 11700 CE when spot is at 11150 is Rs.12, then when Nifty moves to 11300 (150 point move) the premium is likely to move by 150 * 0.05 = 7.5 points.

Hence the new premium will be Rs.12 + 7.5 = Rs.19.5/-. However the 11700 CE is now considered slightly OTM and not really deep OTM.

Most important to note – the change in premium value in absolute terms maybe small (Rs.7.5/-) but in percentage terms the Rs.12/- option has changed by 62.5% to Rs.19.5/-

Conclusion – Deep OTM options tends to put on an impressive percentage however for this to happen the spot has to move by a large value.

Learning – avoid buying deep OTM options because the deltas are really small and the underlying has to move massively for the option to work in your favor. There is more bang for the buck elsewhere. However for the very same reason selling deep OTM makes sense, but we will evaluate when to sell these options when we take up the Greek ‘Theta’. Example: For stock like Jet Airway which moved 130% in single day from 26 to 80+ Buying Deep OTM call is advisable, but for blue chip company and index base trading avoid buying such Deep OTM option.

Speed Up to Gear Up stage 2 & 3 – This is the stage when the option transitions from OTM to ATM. This is where the maximum bang for the buck lies, and therefore the risk.

Consider this – Nifty spot @ 11150, Strike is 11400 CE, option is slightly OTM, delta is 0.30, Premium is Rs.30/-.

Spot moves from 11500 to 11300 (150 point), to figure out what happens on the premium side, let us do some math –

Change in underlying = 150

Delta for 11400 CE = 0.30

Premium change = 150 * 0.30 = 45

New premium = Rs.30 + 45 = Rs.75/-

Percentage change = 150%

Do you see that? For the same 150 point move slightly OTM options behaves very differently.

Conclusion – The slightly OTM option which usually has a delta value of say 0.2 or 0.35 is more sensitive to changes in the underlying. For any meaningful change in the underlying the percentage change in the slightly OTM options is very impressive. In fact this is exactly how option traders double or triple their money i.e. by buying slightly OTM options when they expect big moves in the underlying. But I would like to remind you that this is just one face of the cube, there are other faces we still need to explore.

Learning – Buying slightly OTM option is more expensive than buying deep OTM options, but if you get your act right you stand to make a killing. Whenever you buy options, consider buying slightly OTM options

Let us take this forward and see how the ATM option would react for the same 150 point move.

Spot = 11150

Strike = 11150 (ATM)

Premium = Rs.100/-

Change in underlying = 150

Delta for 11150 CE = 0.5

Premium change = 150 * 0.5 = 75

New premium = Rs.100 + 75 = Rs.175/-

Percentage change = 75%

Conclusion – ATM options are more sensitive to changes in the spot when compared to OTM options. Now because the ATM’s delta is high the underlying need not really move by a large value. Even if the underlying moves by a small value the option premium changes. However buying ATM options are more expensive when compared to OTM options.

Learning – Buy ATM options when you want to play safe. The ATM option will move even if the underlying does not move by a large value. Also as a corollary, do not attempt to sell an ATM option unless you are very sure about what you are doing.

Stabilization Stage 4 – When the option transitions from ATM to ITM and Deep ITM the delta starts to stabilize at 1.

Let us see how this works –

Nifty Spot = 11300

Option 1 = 11100 CE Strike, ITM option, Delta of 0.8, and Premium is Rs.230

Option 2 = 11000 CE Strike, Deep ITM Option, Delta of 1.0, and Premium is Rs.310

Change in underlying = 100 points, hence Nifty moves to 11500.

Given this let us see how the two options behave –

Change in premium for Option 1 = 200 * 0.8 = 160

New Premium for Option 1 = Rs.230+160 = Rs.390/-

Percentage Change = 160/230 = 69.50%

Change in premium for Option 2 = 200 * 1 = 200

New Premium for Option 2 = Rs.310+200 = Rs.510/-

Percentage Change = 200/310 = 64.5%

Conclusion – In terms of the absolute change in the number of points, the deep ITM option scores over the slightly ITM option. However in terms of percentage change it is the other way round. Clearly ITM options are more sensitive to the changes in the underlying but certainly most expensive.

Most importantly notice the change in the deep ITM option (delta 1) for a change of 100 points in the underlying there is a change of 100 points in the option premium. This means to say when you buy a deep ITM option it is as good as buying the underlying itself. This is because whatever is the change in the underlying, the deep ITM option will experience the same change.

Learning – Buy the ITM options when you want to play very safe. When I say safe, I’m contrasting the deep ITM option with deep OTM option. The ITM options have a high delta, which means they are most sensitive to changes in the underlying.

Deep ITM option moves in line with the underlying, this means you can substitute a deep ITM option to a futures contract!

Think about this –

Nifty Spot @ 11200

Nifty Futures = 11230

Strike = 10800 (deep ITM)

Premium = 420

Delta = 1.0

Change in spot = 50 points

New Spot value = 11250

Change in Futures = 11230 + 50 = 11280

Change Option Premium = 1*50 = 50

New Option Premium = 50 + 420 = 470

So the point is, both futures and Deep ITM options react very similar to the changes in the underlying. Hence you are better off buying a Deep ITM option and therefore lessen your margin burden. However if you opt to do this, you need to constantly make sure that the Deep ITM option continues to remain Deep ITM (in other words make sure the delta is always 1), plus do keep an eye on the liquidity of the contract.

I would suspect that at this stage the information contained in this chapter could be an overdose, especially if you are exploring the Greeks for the first time. I would suggest you take your time to learn this one bit at a time.

I’ve considered Reliance as the underlying. The price is 1160 and the expectation is a 50 point change in the underlying due to recent Annual General Meeting on 12th Aug. We will also assume there is plenty of time to expiry; hence time is not really a concern.