Delta as a Probability Tool: Assessing Option Profitability

  1. Trading for professionals: Options trading
    1. Call Option Basics learn the basic Definition with Examples
    2. Call option and put option understanding types of options
    3. What Is Call Option and How to Use It With Example
    4. Options Terminology The Master List of Options Trading Terminology
    5. Options Terms Key Options Trading Definitions
    6. Buy call option A Beginner’s Guide to Call Buying
    7. How to Calculate Profit on Call Option
    8. Selling Call Option What is Writing/Sell Call Options in Share Market?
    9. Call Option Payoff Exploring the Seller’s Perspective
    10. American vs European Options What is the Difference?
    11. Put Option A Guide for Traders
    12. put option example: Analysis of Bank Nifty and the Bearish Outlook
    13. Put option profit formula: P&L Analysis and Break-Even Point
    14. Put Option Selling strategies and Techniques for Profitable Trading
    15. Call and put option Summary Guide
    16. Option premium Understanding Fluctuations and Profit Potential in Options Trading
    17. Option Contract moneyness What It Is and How It Works
    18. option moneyness Understanding itm and otm
    19. option delta in option trading strategies
    20. delta in call and put Option Trading Strategies
    21. Option Greeks Delta vs spot price
    22. Delta Acceleration in option trading strategies
    23. Secrets of Option Greeks Delta in option trading strategies
    24. Delta as a Probability Tool: Assessing Option Profitability
    25. Gamma in option trading What Is Gamma in Investing and How Is It Used
    26. Derivatives: Exploring Delta and Gamma in Options Trading
    27. Option Gamma in options Greek
    28. Managing Risk in Options Trading: Exploring Delta, Gamma, and Position Sizing
    29. Understanding Gamma in Options Trading: Reactivity to Underlying Shifts and Strike Prices
    30. Mastering Option Greeks
    31. Time decay in options: Observing the Effect of Theta
    32. Put Option Selling: Strategies and Techniques for Profitable Trading
    33. How To Calculate Volatility on Excel
    34. Normal distribution in share market
    35. Volatility for practical trading applications
    36. Types of Volatility
    37. Vega in Option Greeks: The 4th Factors to Measure Risk
    38. Options Trading Greek Interactions
    39. Mastering Options Trading with the Greek Calculator
    40. Call and Put Option Guide
    41. Option Trading Strategies with example
    42. Physical Settlement in Option Trading
    43. Mark to Market (MTM) and Profit/Loss Calculation
Marketopedia / Trading for professionals: Options trading / Delta as a Probability Tool: Assessing Option Profitability

Delta as a probability

We can finish our conversation on Delta by looking at a fascinating way to use it: determining the likelihood of an option contract finishing in the money.

Let me explain – When a trader purchases an option, regardless of whether it’s Calls or Puts, what exactly are they hoping for? 

To provide an alternative example, let’s say you purchase the Nifty 9000 PE when the spot price is trading at 9100. In this scenario, the 9000 PE is an out-of-the-money (OTM) option. Your expectation is that the market will decline, resulting in a profit from your put option.

As the spot price decreases below the strike price, the option transitions from being OTM to in-the-money (ITM), which increases the potential profit. To estimate the probability of this transition, you can utilize the option’s delta.

Assuming the 9000 PE has a delta of 0.3, which is typical for a slightly OTM option, you can convert this delta into a percentage. In this case, a delta of 0.3 translates to a 30% probability of the 9000 PE becoming an ITM option.

It’s important to consider this scenario as it reflects the realities of the market. However, let’s now shift our focus to a different situation.

For instance, let’s analyse the 8400 CE, which is trading at Rs.4/-, while the spot price is at 8275. With only two days remaining until expiration, the question arises: should you invest in this option?

From a trader’s perspective, this might seem like a small investment given the premium of only Rs.4/-. On the other hand, if the speculation proves to be correct, there is potential for significant profit. 

However, let’s engage in “model thinking” to evaluate whether this is a prudent course of action.

Considering the 8400 CE as a deep out-of-the-money call option with a delta of approximately 0.1, we can infer that there is only a 10% chance for the option to expire in-the-money. 

Furthermore, with just two days remaining until expiration, the case against buying this option becomes even stronger.

By analysing these factors, we can make a more informed decision about whether to pursue this option strategy.

A smart investor will never purchase this option, but it makes perfect sense to sell it for the premium. Looking at the facts – there is only a 10% chance for this option to end in-the-money, or put another way, a 90% chance of settling out-of-the-money – it’s clear why one should boldly take on this trade!

The delta of an ITM option is usually close to 1, which indicates that there’s a strong likelihood for it to remain ITM at expiration. Consequently, if you’re considering writing/shorting ITM options, consider that the chances are already stacked against you!

It’s essential to understand the numbers and wear your ‘Model Thinking’ hat before taking a trade, as this is what smart trading is all about – making sure the odds are in your favour.

I trust that this has helped you gain a reasonable idea about the initial Option Greek – the delta.

Now let’s understand about Gamma in the next chapter.