Delta (Derivative Pricing) - Explained
What is a Delta?
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Table of ContentsWhat is a Delta?How is Delta Used in Financial Analysis?Examples of DeltaHow delta dictates behaviorDelta Spread
What is a Delta?
Delta refers to a ratio that compares the extent of change in an assets price to the change in derivatives price. For instance, if the price of an underlying asset increases by $1, and the value of option increases by $0.65 for every share (provided all other things being constant), the delta value of the stock option will be 0.65.
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How is Delta Used in Financial Analysis?
The value of delta can either positive or negative based on the nature of option used. For instance, a call option carries a delta value ranging between 0 to 1 as the underlying security experiences a rise in price, the price of call option increases too. On the other side, the delta value of put options varies between -1 to 0 as the underlying asset price increases, there will be a decline in the worth of put option. For instance, if the delta of a put option is -0.33, it means that if the underlying security's price rises by $1, the put options price will be reduced by $0.33. This states that the deltas value of options primarily derives the options value in accordance with the price of the underlying security. The usage of delta is commonly seen in hedging strategies. It is also known as hedge ratio.
Examples of Delta
Lets take an example of a company named BigCorp whose stocks are publicly traded. It does the trading of its stock in the stock market. Its shares of stocks are traded on put and call options. The call options delta value for the company is 0.35. This signifies that if there is a change of $1 in the stock price of BigCorp, it will create an increase of $0.35 in its call options price. Hence, if the shares of the firm are trading at a value of $20, and the call option at $2, an increase in the share price of the company to $21 would mean that the price of call option has increased to $2.35. Put options operate in a totally opposite manner. For instance, if the delta value of the put option for the company is -$0.65, then it means that a growth in the share price of the company by $1 will cause the company's put options to suffer a decline of $0.65. Hence, when the company's share is trading at $20, and put option at $2, the share price hike to $21 will cause a decline in the put options price to $1.35 from $2, hence creating a negative delta of -$0.65.
How delta dictates behavior
The calculation of delta value is done by using a computer software. Delta values have a huge impact on the movement of option prices. Also, it gives investors an idea about their investment strategies. Experts can ascertain the behavior of delta values associated with call and put options, and seems to be highly useful for portfolio managers, hedge fund managers, traders, and investors. The delta behavior of call option is based on three cases: if the option is in the money or profitable, at the money or if the price of the underlying security is equal to the current strike price, or out-of-the-money or when it is not presently profitable. As the maturity period of in-the-money call option comes nearer, their delta values comes closer to 1. While at-the-money call options experience a delta value of approximately 0.5 as they tend to mature, the delta value of out-of-the-money comes to 0 as they are about to expire. The delta value will be around 1 if the in-the-money call option bears a depth in price. Also, it will result in more chances of making the option to perform like an underlying market security. Further, the behaviors of put option delta are highly influenced by in-the-money, at-the-money, or out-of-the-money stage of the option. It is in contrast to the call option. With the tendency to approach the expiry date, the delta value of in-the-money put options becomes closer to -1, at-the-money delta value of -0.5, and out-of-the-money delta value of 0 as maturity period comes closer. The more the depth in in-the-money put option, the more nearer the delta value will be to -1.
Delta spread is a trading approach used in the option market by the traders where they maintain a delta neutral position in the initial stage. They do so by trading options as per the neutral ratio. This results in balancing the positive and negative delta values so as to arrive at the final delta value of zero. Traders use a delta spread for having a profit margin, provided the underlying assets price doesn't experience a big change. The movement of stock in positive or negative directions can have an impact on profits and losses. Calendar spread is one of the most commonly used delta spreads worldwide. It formulates a delta neutral position considering options having distinct dates of maturity. For example, a trader will tend to make sale of near-month call options, and purchase call options with a later maturity date proportionate to the neutral ratio. Because of the position being delta neutral, the traders would neither gain nor lose from little fluctuations in the price of underlying asset. Instead, the trader wishes for price stability. With the near-month calls losing the value of time and maturing, the trader can opt for making a sale of the call options having larger maturities, and generate a net profit.