Delta is a major constituent of the 4 option greeks that is used to measure the rate of change in option prices with respect to the change in the price of the underlying asset. Delta is also known as the hedge ratio as it is used to denote how many Call or Put options are to be bought in order to hedge 1 futures position.
Delta-
Option prices are determined by 4 option Greeks and Delta is one of them. Option Greeks are like the 4 wheels of a car without which the car cannot move, similarly, without understanding the working of these option Greeks (Delta, Gama, Theta, Vega), an options trader cannot determine how to trade in options.
Delta is an important constituent of an option. Delta is the measure of the change of the option premium based on the movement of the price of the underlying asset. Delta ranges from “-1 to 1”.
Delta is also known as the “Hedge Ratio” which means that Delta gives the calculation of how many Put options should be purchased for one long position in futures.
Let’s understand how Delta is interpreted-
Delta for a Long Call option will range from 0 to 1, and the delta for a Short call option will range from -1 to 0.
- The delta of a CE (Call option) bought will range from 0 to 1
- The Delta of a PE (Put option) bought will range from -1 to 0
Now for example, if Nifty is at 15000, hence the Delta of the ATM ( At The Money) Call option will be close to 0.5, as the strike prices move more OTM (Out Of The Money), the Delta keeps on decreasing. The delta of the 15200 Call option will be approximately 0.25 and the Delta of 15400 can be 0.18. Hence you can understand that the Delta value keeps on decreasing as the option Strike moves more away from the Current Market price.
Now let’s understand the use of Delta-
If the Delta of the 15200 Call option of Nifty which is trading at 15000 is 0.25, and the option price is 100, then if Nifty moves up by 100 points then the value of the Call option will be 100+(100 x 0.25)= 125.
Similarly if Nifty moved 100 points on the lower side then the value of the Call option would have been 100- (100 x 0.25)= 75.
In this way, delta determines the change In the price of Options compared to the change in the price of the underlying asset.
Let’s Understand how the Hedge ratio works-
Hedge Ratio is also known as the position Delta where an Options trader calculates the number of Lots of Call or Put options to buy/sell in order to hedge the counter position taken in Futures or cash.
For example, one has 1 short position in futures in a particular Asset and the Delta of the ATM Call option is 0.5 then he will have to buy 2 ATM Call option in order to achieve the hedge for the short future position as the total Delta of the Long Call options will be (0.5 x 2)= ‘1’ which will be equal to the Future. In this way, any losses faced in the Future will be offset by the Option positions as the Delta is equal to 1.