The last chapter offered a glimpse into the Delta option Greek, while also providing a deeper view into model thinking. What I mean by that is the previous chapter exposed different options trading views – hopefully you now have a better understanding of how to examine options beyond just one dimension.
Moving ahead, if you hold a bullish view on the markets, your trading strategy might not involve straightforwardly “purchasing a call option or earning a premium by selling a put option.”
You may want to consider taking a bullish view on the market, with an expectation of a 40 point increase. To capitalise on this move, investing in an option that has a delta of 0.5 or higher would be wise, as it should yield at least 20 points.
It is evident that comparing the two thought processes reveals a contrast; the initial one being rather unstructured and spontaneous while the second was formed through use of clear metrics and data. Our earlier chapter discussed a formula that anticipated an increase of 20 points in the option premium.
Option Delta * Points change in underlying= Expected change in option premium
The above formula is only the first step in the game. As we uncover more of the Greeks, our evaluation process becomes increasingly quantitative and trades become more logical. Numbers and equations will drive our strategy from here on out, leaving little room for ‘casual trading thoughts’. Some people are successful with that approach, but it’s not for everyone. Taking a numerical perspective gives you much better odds – the kind of edge that comes from developing model thinking.
When analysing options, it’s important to keep the model thinking framework in mind; this will give you a structure to make your trades organized.
– Delta versus the spot price
Earlier, we analysed the importance of Delta and delved into how one can use delta to forecast changes in premiums. To quickly refresh your memory here is a brief review of the previous chapter –
Allow me to draw insights from the third point mentioned and draw some conclusions.
Let’s take the Nifty Spot at 8305, the strike under consideration is 8250, and the option type is CE (Call option, European).
Since the 8250 CE is an OTM option, the Delta should be in the range of 0 to 0.5. Let’s assume a Delta value of 0.3 for this example.
As the spot moves from OTM to ATM, the Delta value should increase. Let’s assume the Delta to be 0.5 for this case.
If the spot moves from ATM to ITM, the Delta value should approach 1. Let’s set the Delta at 0.8 for this example.
The spot has increased, causing the option to move from ITM to OTM. As a result, the Delta will decrease from 0.8 to 0.4, for instance.
The change in the spot value influences the moneyness and Delta of an option, impacting its pricing and risk profile.
This is an essential point to note – delta is a variable and will alter when the underlying’s value shifts. Consequently, if an option has a delta of 0.4, its worth will be subject to fluctuations depending on the value of spot.
Examine the chart below for a depiction of delta relative to the spot price. It is a general representation and not pertinent to any specific strike or option. There are two lines easily distinguishable on it –
This chart is captivating and we should start by simply examining the blue line, disregarding the red line. The blue line symbolises the delta of a call option. As you look over the graph, there are certain notable elements to consider; here are some of them: as the spot price fluctuates, this can also result in a change to the moneyness of the option.
Similar characteristics can be observed for the Put Option’s delta (represented by the red line).