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how the gears turn
Pricing Options: Probabilities
Introducing Delta and how probabilities affect option prices
Mo Money, Mo Probable
Probabilities play a direct role in option pricing. We estimate the probability of an option using the metric
Delta is one of several used to measure option risk. It serves several purposes and estimating probability is the first. As you can see in the chart below, options have low deltas, meaning a low probability of expiring ITM. ATM options have around ± 0.50 deltas, meaning they have about a 50/50 chance. ITM options have the highest deltas which means they have a high probability of expiring ITM. Generally speaking, options with high deltas are priced higher than options with low deltas. The minimum delta per option is 0 and the maximum is ± 1.00.
Delta is one of several used to measure option risk. It serves several purposes and estimating probability is the first. As you can see in the chart below, options have low deltas, meaning a low probability of expiring ITM. ATM options have around ± 0.50 deltas, meaning they have about a 50/50 chance. ITM options have the highest deltas which means they have a high probability of expiring ITM. Generally speaking, options with high deltas are priced higher than options with low deltas. The minimum delta per option is 0 and the maximum is ± 1.00.
Delta and Direction
Notice how the deltas of the calls are positive, and the puts are negative. These permutations are simply an indicator of directional risk – delta's second function. As the underlying price rises, a positive delta indicates the option will increase in value. A negative delta indicates the option will decrease in value. The delta's magnitude estimates how much the option's price will change.