Mastering Derivatives: Beware of delta!

Risk is the possibility of loss in the future. If you are long on futures, the risk is that the underlying could decline during the life of the futures contract resulting in losses on your futures position. If you are short on futures, the risk is that the underlying could move up. Risk associated with options is somewhat different.

The time value of an option must be zero at expiry. That means the amount you pay as time value when you buy an option is not a risk! It is a sure loss. So, how is risk defined in relation to options?

This week, we discuss risk associated with options and why traders bet on at-the-money (ATM) and OTM (out-of-the-money) options despite facing losses from time decay.

Delta gains

Suppose you buy the next-week 18300 Nifty call. With the index trading at 18225, the 18300 call is OTM. Therefore, the option price, 139 points, consists only of time value. This entire value must become zero at expiry. The call loses value with each passing day, captured by the option’s theta. Yet, a trader is willing to buy the strike. Why?

The reason is because the trader expects the 18300 call to increase in price. But if time decay pushes the price down, how can the call price go up? The answer is because the call price moves in the same direction as the underlying.

So, when the underlying price increases, the call price moves up, captured by the option’s delta. In other words, the trader is betting that gains from delta are greater than the loss from time decay. The risk of buying an ATM or OTM option, therefore, is not that you will lose because of time decay. Rather, the risk is that delta will not increase enough to generate gains despite losses from time decay.

Note that if an ATM option becomes ITM, the gains are greater because intrinsic value moves one-to-one with the underlying. Suppose the Nifty index moves to 18300 four days after you setup the position, the long call would have gained just three points. That is because gains from delta is not enough to dominate the loss from time decay. But if the index moves to 18400 during the same period, gains could be 70 points; gains are higher because delta increases from 0.46 to 0.64 as the option gains from intrinsic value.

Volatility risk

An increase in volatility increases the delta of an ATM call option, while it decreases the delta of an ITM (in-the-money) call

Optional reading

A long option position also has volatility risk. An increase or decrease in volatility feeds into an option’s delta; an increase in volatility increases the delta of an ATM call option. A decrease in volatility has the opposite effect. Interestingly, an increase in volatility decreases the delta of an ITM (in-the-money) call, as the option has a greater chance of expiring ATM. Finally, when you short an option, your risk is that the loss due to increase in delta could be greater than gains from time decay.

The author offers training programmes for individuals to manage their personal investments

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