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Determining Your Option's Profit Potential with Delta
by Kevin MatrasAugust 17, 2012 | Comments : 0 Recommended this article: (0)
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You can quickly tell which options will potentially give you the biggest return on your investment by looking at its delta.
Delta is a way to measure how much an option will increase or decrease in value based on the change in the underlying stock.
For example: a delta of .60 or 60% means the option will move or change in value equal to 60% of the underlying stock's price change, which means a $1.00 rise in the stock should see a 60-cent rise in the option premium. If the stock fell by -$1.00, the option should decrease by -60 cents.
There's second part though to understand this fully.
The delta will change (either increase or decrease), in general, based on how 'in-the- money' or 'out-of-the-money' your option becomes.
For instance: let's say a stock is trading at $85 and you had a $95 out-of-the-money call option with 4 months of time on it; that option might have a delta of .41 or 41%. Let's also say that option was priced at 6.00 or $600.
Now let's say the stock increased by $10. This means that out-of-the-money call option with a delta of 41% would've increased by $4.10 or $410.
Now, that option is at-the-money.
Remember, the option's delta will increase or decrease based on how 'in-the-money' or 'out-of-the-money' the option becomes.
So now your option is at-the-money. Instead of your delta being 41%, it might now be 60%. If the stock were to then increase another $10, that option would now increase by another 60% (60% of the $10 move) or $6, i.e., $600.
And as the price goes up, and the more your option gets 'in-the-money', the bigger your delta will become until it gets to be 100%.
Likewise, the further 'out-of-the-money' the option gets, the smaller the delta becomes.
So when you're deciding what option to buy or sell, look at the delta so you can get an idea as to how much your option will increase or decrease based on the underlying price of the stock.
In a future article, I'll go over some techniques for choosing when it's best to buy out-of-the-money options and when it's best to buy in-the-money options in an effort to balance your investment dollars while maximizing your gains and your delta and minimizing your risk.
But knowing your option's delta is one of the keys to picking the right option to get into.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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