How to Use Delta When Trading Options | Options Crash Course

[Music] i'm jim schultz and welcome back to the options crash course man we are rounding the bases and finishing off week number one here today let's pop right in because we have an unbelievable amount of things to cover today so i don't want to waste any time today we are in episode number four we are going to cover probability direction and profit or even profit direction and probability as it is written on the slide either way you want to do what it works it's kind of like two plus three and three plus two but here is where we've been so far this week so a few days ago when we started the crash course we covered the source of all strategies on day number two we deconstructed some option prices yesterday we talked about extrinsic value extras and then today we are going to cover profit direction and probability and so let's go ahead and dive right in so here's what's pretty cool about these three measurements they can all be sourced back to the same metric so there is actually one variable that addresses all three of these ideas all three of these concepts simultaneously and that is the options delta now delta is arguably the most versatile the most applicable of all the variables that we utilize of all the different metrics that we look at that we lean on that we analyze to try to build our portfolios and you know select our strategies you could make a pretty good case that delta is the one that we use more than any other if we go back to the black shells option pricing model so the black shells option price mod we covered that just a couple of days ago and what we did i said hey we're going to revisit this thing a handful of times well here is one inside of that handful we're not going to dive into the equations anymore we're not going to pull out any of the math from the model because that's not really the direction that i want to go with this but i want us all to be what be aware of something very very important the black shells model in and of itself is extremely valuable because it measures the options price or as we learned just yesterday we can flip it around and calculate the implied volatility either way the model on the surface level is extremely viable but if we actually dig a little bit deeper for all of my mathematical junkies out there if we take some partial derivatives of that model with respect to different variables like price like time like volatility which is where we're going next we learn some new interpretations of the model we learn some brand new information about the model and how it changes when these different elements of the marketplace change and that's actually what delta is it is the first derivative of the black shells option pricing model with respect to price now for those of you that remember your you know pre-calc or calc 1 or calc 2 days you remember that hey a partial derivative shows me how when one thing changes how something else changes so here with delta if i take the first derivative with respect to price what i'm actually trying to figure out is this how is the options price going to change when the stock price changes if i take the first derivative of the black sales model with respect to stock price i can find out how the option price will change when the stock price changes and that effectively is what delta begins to measure at least on the surface level now delta is one of a group of variables that are more commonly referred to as the option greeks and we're going to talk about a few of these you know in the coming days and the coming weeks i would say as i kind of alluded to a couple of minutes ago this is probably the greek that we use more than any other this is probably the one greek that provides the most amount of value now you could make a case that the one that we're going to cover on monday might actually be more valuable but since this is my crash course i'm going to do it the way i want to do it and delta is indeed the champ if we look at delta we can surmise profit direction and probability as we're going to see in the next you know 17 or 18 minutes but if we dig a little bit deeper as we're going to begin to unpack today but that will continue to you know look at throughout the course delta measures a couple of additional things that are just you know tiny little offshoots off of this profit direction probability kind of source it gives us a gauge of our directional risk which we're going to begin to see that a little bit in just a couple of minutes but it also gives us a gauge of our probability of profit or pop as we like to refer to that as here at tastytrade so this is where we are headed today for the next you know 18 or 19 minutes all right so let's begin with that textbook definition so we just laid out the textbook definition a couple of seconds ago and it basically is this what delta measures is when a stock price changes how will the options price change this is the textbook definition i can say this from first-hand experience when i taught undergraduates when i taught mba classes this was in the literal textbooks that we used for those classes but here's what's really interesting as traders right we're not in classroom anymore we're not trying to pass exams anymore we're not turning in homework anymore as actual traders that are building real portfolios with real money trying to make real-time decisions this is actually the interpretation of delta that we use the least this is actually the interpretation of delta that provides the least amount of value in terms of the different ways that we can utilize and apply this one variable but from a purely foundational standpoint let's say it's very important that we begin with this as our baseline and then branch off accordingly in the next couple of slides so let's work through what's on this slide if you start with the top gray card on the left there you see okay i have an option that has a 30 delta what does that mean well if you go all the way to the right so skip over what's in the middle just for a brief hot second we'll come back to this in in just a minute if you go all the way to the right here is what that means it means if the stock moves by one dollar the option price is going to change by 30 cents now don't worry so much right now about is it going to go higher is it going to go lower is it going to be a profit is it going to be lost that's not that important right now let's paint with a broader brush than that let's not use a scalpel just yet let's just understand the basic relationship of an options delta and then if i look at a 7d delta so the the bottom gray card there on the left if i skip all the way over to the right skip over those arrows skip over those quotations i see that a one dollar move in the stock is going to equate to a 70 cent move in the option okay so now let's rewind the tapes a little bit let's dig into what you see there in the center i wanted to now as i've said you know i don't know half a dozen times already and i will say many many more times over the course of the next two and a half weeks i have to make certain concessions as i go through the content for this crash course but i was not willing to concede this point that we're going to go through for the next 90 seconds because this is an unbelievably common point of confusion amongst new option traders and here's what i mean when you look at a delta so let's go back to the 30 delta when you look at a delta here is what you need to be aware of you might see that delta presented as a decimal so .30 you might also see that delta presented as a whole number so 30. those two deltas are the same those two deltas mean the same thing now some of you out there thinking jim how in the high heavens could those possibly be the same thing they're so different well what we need to do is we need to back up a second and we need to take a look at option quotations just as a whole remember option contracts are per 100 shares but options are normally quoted on a per dollar basis so this is not on the slide but just try to follow me kind of verbally through the forest here an options quote might be something like one dollar right like if i'm talking to my trader friends and we're you know we're at a party and we're talking about the ibm options that we just sold you know i might say hey i sold that option for a dollar right everybody in that conversation knows what i mean is it's one dollar per share but on a per contract basis it's actually 100 because there are 100 shares per contract well delta in terms of its quotations and its presentations it follows the exact same framework you could communicate your deltas in terms of a per share basis so that would be .30 or you could communicate your deltas on a per contract basis so 30 those are pointing to the same value those mean the exact same thing now of course you could have times where you know your whole number delta so the 30 that you see here in the quotations could be so close to zero that it is a fraction itself that's of course possible so be aware of that but that's not usually going to be the case it's going to pretty much follow the relationship that we've just seen so if i look at a 70 delta right just really quickly 0.70 and 70 mean the same thing it just depends on whether or not you're talking in terms of a per dollar basis or a per contract basis now one final remark about this point just to just uh hopefully clarify some things for you all that you're going to see especially if you guys remain on the tasty trade network and you follow some more of our content whether it's from myself or mike or nick or katie or tom or tony or liz or jenny or pete or anybody you're going to notice that when it comes to option prices we all almost exclusively communicate in terms of a per dollar basis so again i sold an ibm contract for a dollar i sold an apple contract for 75 cents we don't talk in terms of per contract basis like a hundred dollars or 75 however with deltas we almost never use the per dollar quotations in terms of our communication with one another so in other words if i had that 30 delta option i would never say to somebody else at tastytrade like hey i've got this option on and they say well what's the delta i would never say it's 0.30 i would say it's 30 or i would say it's 70. so i wanted to point that out because again my assumption here is that you don't know anything my assumption here is that you are a blank slate and one of the things that i've learned in my many many years of teaching this subject that the terminology alone is overwhelming the terminology alone the language and the syntax and the vernacular is so challenging because there's so many things that are floating around and what makes it even more confusing is a lot of them are being used synonymously a lot of them are being used interchangeably so i wanted to point that out okay so faq what is better higher or lower well we could take the easy way out here and we could just say that well it depends but i mean as we've all learned from rocky iv there is no easy way out so what we're going to do is we're not going to do that we are going to say that the better option here is lower now i don't have time to fully unpack why that's the case just yet because we don't know enough at this point for it to make complete sense so we're gonna put that on the shelf for just a couple of days but we'll bring it back down when the time is right so there's your textbook definition of delta all right what about the directional element of delta what about the directional exposure that we have with delta we're going to notice on this next slide that it's very similar to what we just saw on the previous slide but it has a slightly different interpretation that allows us to utilize delta's information in this way a lot more frequently if i have 100 shares of stock that by definition has a 100 delta and the reason why that's the case is if you go back to the literal textbook definition of delta remember it's when the stock moves how does the option move well this would basically be saying when the stock moves how does the stock move so if the stock goes up by a dollar the stock goes up by a dollar if the stock goes down by a dollar the stock goes down by a dollar right so stock always has a 100 delta with itself right 100 shares of stock will have a 100 delta well if i have that same 30 delta option on now that we understand that textbook definition we can also say that while i have 30 percent of the directional exposure that i would have if i had a full stock position instead or if i had a 70 delta on i have 70 percent of the directional exposure that i would have if i had a 100 share stock position on instead now naturally this begs the question why would i want less exposure like why wouldn't i want to have full exposure to the stock market and to this stock position and to this you know specific strategy that i've selected and that's that's a really good question and let me go ahead we're going to hop on the soap box for this answer because this is very very important so again if you're multitasking if you've got 37 tabs open come back to me for two minutes this is really really important the market stock market is totally unpredictable the market stock market is completely random i can assure you that nobody really knows what's going to happen now i'm aware especially if you're watching this live although you know in today's age you don't even need to be watching this live for what i'm going to say next to be true i know that right now in real time there are some prognosticators that are prognosticating about market direction right now and they're being very well compensated for those prognostications i can assure you they have no idea what they're talking about i can assure you they do not know what is going to happen next because think about it for a second guys if i knew what was going to happen next if i legitimately knew what was going to happen next what would i be doing i would not be going through an options crash course on the tasty trade network as amazing as my position is and it is right as blessed and as grateful as i feel for my job adaptation trade they're amazing if i had a rock solid system that i knew would work i would be in fiji trading that system and i wouldn't tell anybody about it you wouldn't even know who i was you would never hear a peep for me i would not be out in the public forecasting my thoughts and forecasting my ideas i would just be trading that system and so i don't know what's going to happen you don't know what's going to happen and those prognosticators don't know what's going to happen so let's bring this back full circle why is this important well in a market that's totally unpredictable and in a market that is completely random if i can lessen my directional exposure a little bit right now again we're not talking about the long term we're not talking about decades right everybody can agree the stock market's going to go higher over you know a period of decades and it should for a bunch of reasons that i'm not going to talk about here because it's not relevant to what we're talking about but in the 30 45 60 day time horizon where we feel like there's the most opportunity that we're going to talk about later in this crash course nobody knows what's going to happen so if i can mitigate my directional exposure a little bit right if i can kind of water down the directional element of my p l and maybe lean on some other things which i'm going to show you guys how to do that can be a very very positive thing for my portfolio so i just wanted to just want to hop on the soapbox man for a little friday afternoon soapbox edition so alright so directional exposure why would i want less exposure that is why you might want to consider less exposure okay so the last interpretation or definition of delta is going to be as uh the or a probability of the option expiring in the money so what do i mean by that well let's work through this slide there's actually quite a bit going on here so let's kind of unpack this at a a reasonably gradual pace so let's start in the center if you look at that blue box in the center let's suppose and we're going to see this in a real-time example on the next slide so right now just try to loosely grab on to what i'm talking about and then you'll see it come to life with actual real strikes and real prices here in just a second if that blue box represents my at the money strike which again we just learned just the other day that that means that the stock price is at this level the delta of that strike the probability of that strike expiring in the money it doesn't matter if you're talking about calls or puts at this point is going to be 50 now why is it going to be 50 well again let's tie together you know what i'm saying now with what i just said three or four minutes ago if the market is totally unpredictable and the market is completely random then it's a 50 50 proposition that the market goes higher or lower from this point so it's a 50 50 proposition that that at the money strike that you're looking at that you know might be in the october expiration cycle or the november expiration cycle or any expiration cycle for that matter it's a 50 50 proposition that that expiration cycles strike is going to expire in the money because again whether the market goes higher or the market goes lower is basically a coin flip now when you start to weave in things like you know positive drift and and the slow upward grind of the market over time you could of course make the case that it's more like 53 47 you know skewed to the upside but for all intents and purposes let's just call it 50 50 for the 30 45 60 day time horizon okay from that at the money strike let's suppose that if i move higher on the screen so higher on this slide let's suppose that those are lower strikes and if i move lower on the screen let's suppose that those are higher strikes now i know that is super confusing because you're like why would i ever do that because when i go up i don't know about you jim but i think higher and when i go down again i don't know about you man but i think lower and i'm with you man i'm with you 100 but this is the convention that was on the trading floor for many many years and many many decades so this is what you're going to see inside of the tastyworks software since it was built by traders so i want to mirror that structure to the best of my ability so that you're not totally surprised when you get in there and see something completely unfamiliar if we look on the left hand side so let's focus on those kind of slate colored cards those are going to be our call options right in the platform the calls are always on the left and the puts are always on the right if i look at that upper left card those are going to be the lower strike calls lower strike relative to the at the money strike so by definition those are going to be the in the money calls right so for example the strike might be a hundred where the at the money strike where the stock is might be 120 right so those call options are in the money for all the reasons that we talked about just the other day right they have value to the long side of the contract okay to tie together that idea with what we're talking about here you're going to see that the deltas on those options are going to be greater than 50 because the probability that those options expire in the money is going to be greater than 50 now why is that the case well it's actually quite simple if those strikes are already in the money then they have a bit of a head start in terms of the chance that they stay in the money that they expire in the money because again the market's completely unpredictable it's totally random we don't know where it's going to go but if this thing is already 10 or 20 or 30 points in the money the likelihood that it stays in the money is much much higher so it's going to be greater than 50 if we go down to the bottom slate card these are going to be your out of the money calls these are going to be your higher strike calls these are going to have a probability that's less than 50. so they're going to have a delta that's less than 50. and why is that the case well you can probably kind of see where i'm going to go with this now right if the strike is higher than the current stock price so the stock price might be 120 and the strike here might be 130. it's like well i need i need the stock to rise up to the strike price in order to get into a 50 50 proposition so right now i must be in a worse than 50 50 proposition right the odds must be against me right now because i need that stock movement in a world that is so unpredictable if we move over to the other side the yellow cards these are your put options we'll go through these a little bit more quickly because i want to leave at least a couple of minutes for this real-time example on the next slide the lower strike puts now these are going to be you out of the money puts so they're going to have probabilities that are under 50 because again they need a little work from the stock price to get to the at the money strike and make this a 50 50 proposition and then of course the higher strike puts those are going to be your in the money puts and your probabilities here are going to be greater than 50 so the deltas are going to be greater than 50. so let's put all this together for the final 90 seconds today and let's take a look at this in real time so what i've done here is i'm still using spy to kind of stay consistent with the examples we've done so far it's you know easily the most actively traded instrument in the whole world so it it serves itself well as a constant and consistent example that we will lean on so if we look at the price of sby i just pulled this off you know a couple of hours ago the price was about 335 right you can see that in the white box there to the upper left so then if i if we look at the 335 strike both the calls and the puts you can see that as denoted by the white rectangle in the center of the screen if you look over to the left you can see that the 335 call has a delta of 52 so approximately 50. you can see that the 335 put has a delta of 48 so again approximately 50 right now spy is not exactly at 335 it's a couple pennies off so that's one reason why the deltas aren't exactly 50 but another reason is the market is a living and breathing thing right there's all kinds of moving parts that are always impacting every single variable in real time in every single moment and so it's almost impossible to be able to isolate you know just one or two effects on a given variable and and and draw out what we're looking for you know to to a to a perfect theoretical underpinning and so that is why a lot of the time what you're going to find is things in the real world are slightly off from what you might find you know in a textbook and so in other words when you go from theory to practice sometimes things look a little bit different so you might want to check that program out but anyway if we look at the call options which are in the yellow boxes over there to left i've been waiting 26 minutes to use that line so there you go if we look at the 331 call this is going to be your in the money call right because again the stock price is 335 the strike price on this call is 331 and so the delta here is 59. delta's 59 probability of it being in the money 59. if i go down to the bottom yellow box the 338 call this guy is slightly out of the money so you see the delta is less than 50 in this case it's 46. and if we go over to the right here in the final 30 seconds if you look at those aqua boxes the 331 put now is the out of the money strike so its delta is only 42 and then the 338 put is the in the money put strike for this example so its delta is 53 so now hopefully my goal with this slide is just so that you guys can see how this all comes together and you can visualize delta in the platform for a real stock and a real position and potentially a real strategy so all right so week one is in the books guys monday what are we going to do i'm going to take a couple breaths over the weekend and then episode number five is coming up on monday we are going to talk about the natural decay of options and here is here's where we're going with that man all options are marching towards their demise and we can benefit from that reality so i hope i will see you guys there don't forget guys you can always email me jaysholtz tastytrade.com you can follow me on twitter at jay schultz f3 i would love to hear from you guys as always but if you guys are watching this live in real time we have bootstrapping in america coming up next in the meantime guys trade them small train them heavy and stay generous see you guys on monday you

Channel: tastytrade

Views: 29,084

Rating: 4.9129252 out of 5

Keywords: moneyness, option's implied volatility, short options unlimited risk, investing, finance, how to, education, curriculum, course, learn, trading, options, tastytrade, portfolio, learn to trade, stock, basics, put, call, trading strategies, trade management, intro to options, options 101, building blocks, transaction, option contract, shares, buy, sell, profit, option strike price, delta, option delta, probability of profit, directional risk, first derivative black scholes model, OTM delta, ITM delta

Id: 9BJTvFNo6zg

Length: 26min 50sec (1610 seconds)

Published: Mon Sep 14 2020