How to use Delta to increase your odds of success in options trading
There is another interesting application of Delta. We can use Delta to measure the likelihood of an options contract expiring In The Money (ITM).
When a trader buys an option irrespective of Call or Put, he expects the option to expire in the money so that he would be in profit. For example, what do you expect when you buy Nifty 19500 PE when the spot is trading at 19600? (Note 19500 PE is an OTM option here). Obviously, the trader will benefit only if the market falls.
In fact, the trader hopes the spot price to fall below the strike price so that the option transitions from an OTM option to ITM option – and in the process the premium goes higher, and the trader makes money. So, here comes the Delta to equip the trader with the knowledge of Delta so that he doesn’t jump into the trade, but does a little bit of math.
The trader can use the Delta of an option to figure out the probability of the option to transition from OTM to ITM.
In the example 19500 PE is slightly OTM option; hence, its Delta must be below 0.5, let us assume it to be 0.3 for the sake of understanding.
Now, to assess the probability of the option to transition from OTM to ITM, simply convert the Delta to a percentage number. When converted to percentage terms, delta of 0.3 is 30 per cent. Hence, there is only 30 per cent chance for the 19500 PE to transition into an ITM option.
Sounds interesting right! Now assume this real-life market situation –
• 20000 CE is trading at Rs10
• Spot is trading at 19500
• There are two days left for expiry – would you buy this option? A trader would think that this is a low-cost trade, after all the premium is just Rs 10 hence there is nothing much to lose. In fact, the trader could even convince himself thinking that if the trade works in his favour, he stands a chance to make a huge profit.
Fair enough, in fact this is how options work. Let us look at this trade with another perspective 20000 CE is deep OTM call option considering spot is at 19500.
• The delta of this option could be around 0.1.
• Delta suggests that there is only 10 per cent chance for the option to expire ITM
• Add to this the fact that there are only 2 more days to expiry. So, the trade is not lucrative enough.
A prudent trader would never buy this option. However, it makes perfect sense to sell this option and collect the premium? Think about it – there is just 10 per cent chance for the option to expire ITM or in other words there is 90 per cent chance for the option to expire as an OTM option. With such a huge probability favouring the seller, one should go ahead and take the trade with conviction.
We know that the delta of an ITM option would be close to 1. So, this means there is a very high probability for an already ITM option to expire as ITM. In other words, the probability of an ITM option expiring OTM is very low, so cautious while shorting/writing ITM options as the odds are already against the trade.
Smart trading is all about taking trades wherein the odds favour you, and to know if the odds favour you, you certainly need to get your math right.
(The author is a homemaker, who dabbles in stock market investments in free time)
