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Generate income with options
In other words, Delta is not fixed, the more the option becomes ITM the higher the Delta becomes, and the more sensitive the whole option becomes to the underlying stock’s price movement, if the directional trade goes well and the options moves a lot ITM, then Delta will tend towards 1, that means one dollar favourable move on the stock makes your option one dollar more valuable.
Here we can see how Delta behaves relative to where the stock’s price stands relative to the option’s strike price:
This works in your favour if you are a directional stock trader, and even though you may buy options with a Delta of say 0.5 or 0.6, you know that if you are right Delta will soon become much higher.
Delta pattern versus the underlying stock’s movement
There’s this other parameter called Gamma that actually tells you the rate of change of Delta for every dollar of stock price movement. Generally, you should not be discouraged when you see a low Delta, equally you should pay attention to option premiums, since ITM options are more expensive than OTM ones, you have to pick the one that is best suited to the specific directional stock trade, and ask the question; ‘will I make money if the move does take place?’ Because obviously other scenarios may happen too, the stock may only make 50% of the expected move, or it may just take much longer for the move to begin.
More to the point, the important issue is the non-linear profit pattern of options when compared to stocks and futures trading, this is much more the case in more complex strategies, but it can happen even in simple directional trades, implementing simple long Calls and long Puts. You have to make sure that you make a decent return even if the stock only gives 2 or 3 days of favourable move, or just 50% of the initial, expected move.
Many traders make the mistake of attempting to make directional option trades, on large magnitude stock price movements, by buying way OTM (way out-of-the-money) options, these options have a very low Delta, it can be as low as 0.05, the good thing is that these OTM options are very cheap, if the move does happen as expected, and it is large, they will make a lot of money, but during the first few dollars of stock movement, while still at the OTM phase, the option only gains $0.05 for every dollar the stock moves in their favour!
As long as you are adequately financed, and can afford the deep-In-The-Money options, then you are better off buying those instead, they will cost more, but they have a higher probability of making money, even if the stock doesn’t make the expected strong move, you still make money from day one! From the slightest price movement.
Most savvy option traders who implement directional trades, pay great attention to the probability of the trade being successful, and not how much the option will cost!
As we saw on the Delta curve, starting with a Delta of 0.5 or even 0.4 will give a great advantage when compared with the Delta of 0.05 of the cheap OTM option.
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