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Lesson in Course: Derivatives and options (advanced, 6min )
I understand the difference between in-the-money and out-of-the-money options. How do I know which option contract is for me?
Most professional poker players and gamblers in Vegas spend a lot of time understanding each play to determine the amount of money at risk and the percent chance they have to win it big. The ones that are good at it go on to build profitable careers and avoid the pitfalls of losing everything on a bad bet. If we are to speculate with options, we should do the same.
Let's review the basics of delta and some helpful ways we can use delta.
Delta provides an indication of the price sensitivity of our options to changes in the underlying stock price.
Let's use a working example to understand the percent change.
Putting it all together, we can expect to pay $186 ($1.86 x 100 shares per contract) for each of these in-the-money call options. As a rule of thumb, we can expect to lose around $42 ($0.42 x 100 shares per contract) for every $1 per share the stock decreases without factoring in gamma.
Delta also gives us an estimate for the chance of the option maturing in-the-money.
A 42-delta means buyers and sellers of the call option are collectively guessing that the option has a 42% chance to finish in-the-money at maturity. It's important to know that this percentage is just an estimate and not a guarantee. The percentage can be based on a bunch of factors including market sentiment, interest rate risk, dividends, or supply and demand for the options contracts. The market can change anytime, and the odds can swing quickly in or against our favor.
Delta is a very versatile tool for us to get a peek at what's behind the scene for options. We've just started to cover delta on a beginner level and it's important for us to make sure we've understood delta. We need to understand how to apply our knowledge when looking at different options contracts. Advanced strategies covered in future lessons require mastery over delta and other Greeks.