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March 9, 2022
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Choosing Which Option – Delta and Theta
by Wendy Kirkland

A collection of statistical values (expressed in percentages) called the Greeks give the investor a view of how the stock has been performing. These statistical values can help decide which option strategies are best to use.

The market makers use Greek designations in their calculation of option pricing: Delta, Gamma, Rho, Theta, Vega. Here we are only going to talk about the two that are important in checking out and choosing which option to purchase: the Delta and Theta.

Delta is a theoretical value change in the option’s price based on a change of the equity’s value. Specifically, this is the expected change in the option’s price given a one-unit change in price of the underlying’ futures contract. The range is between 0 and 1.00. This number changes as the market changes.

At your brokerage account, when you’re in the process of choosing which option to purchase, you’ll need to locate where the Greeks are located. Often there is a drop down box where you can select the Delta or historic or implied volatility. This step is as important to any other information in your decision making. You want a delta that is as close to 1.00 as possible.

Let’s say you decide on an option that is .78. This means that for every dollar that the stock price goes up, your option price will advance $.78 cents. If it were to be 1.00 on an option that was well up in-the-money, the option price would advance a dollar for every dollar increase in the stock’s price. Higher deltas come the deeper you to with in-the-money options. The ideal entry Delta is between .60 and .70.

What you want to avoid is the lure of an inexpensive option that is out-of-the-money. At first you think you found a great bargain – only $1.75 per share. You imagine getting several contracts for only a few hundred dollars. But then, you checkout the delta, and find it’s .037. For every dollar move of the stock’s price, you gain $.037 cents. At the rate of $.03-.04 cents, it will take a long time for the option to cover the spread cost between the ask and bid price and the fees for the option transaction.

Theta represents the change in an option’s value based on one-unit (7-day) change in time, until the option is 7-days out from expiration and then it changes to a 1-day time frame.

Theta is not used as much in the decision making process, but is used more as you close in on your expiration date. Let’s say you are forty days out from your expiration date. You plan to sell 30 days before that day to preserve the option’s time value, but the underlying is in a period of horizontal movement. You check the theta value, which tells you the amount that your option per share is decreasing in value. If that value is .192, for example, that means you are losing a little more than $.19 cents a share or $19.20 on your account per week. If your option is waffling up and down, or running horizontal, weigh the cost of your theta loss versus waiting to see what might happen over the next few days until you planned to sell anyway.

The fair market value of an option or Theoretical Value is as predicted through the use of a mathematical formula. The formula takes into account the following factors: strike price, the current price of the underlying, interest rates, time remaining until expiration, dividends (if any), and implied volatility. If you click around on the chain page on your brokerage website, it should bring you to theoretical value information on that option. Often this information is located around the Greeks.

The theoretical value shown for each option helps determine whether your option is fairly priced at the moment, using the current implied volatility. Theoretical value might say that the value is $1.83, but the ask price is $1.96. You would question whether the additional $.13 or $13.00 on the contract of 100 shares is too much to pay. Perhaps, the next option, the one that’s deeper in-the-money is a better value, where the theoretical value is closer to the ask price.

Conversely, if the implied volatility is less than the historical volatility, the option price might seem a bargain if it is priced below its theoretical value.

 
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