I've been talking about delta for years on this Options 101 page, probably more often than some of you want to hear about delta. However, there's always something new to learn about delta or at least about how it relates to current trading conditions. I came across an article a couple of weeks ago that prompted this newest delta-related piece.

For those of you new to trading or at least to the Greeks of options, delta tells you how much a particular option, option position or entire portfolio of options trades will move with a point move in the underlying. For example, if I have a single option with a delta of +0.70 or +70, if the quote sources already applies the 100 multiplier, then my option position is likely to gain about $70.00 for each point the underlying climbs. Of course, that's only true if volatility stays relatively stable and the climb happens over a short period of time. The option is likely to lose about $70 if the underlying drops a point under the same conditions.

If I have a combination option position such as a butterfly and the whole position has that same delta, that whole position will gain or lose approximately the same amount, too, under those conditions. Ditto a whole portfolio of option strategies based on the same underlying, if the whole portfolio has that same delta value. That would be a pretty flat delta for a whole portfolio of options trades on the same underlying, though! It might be a bit of a trick to keep it so flat.

In recent articles, I have touched on my attempts to find the ways to best hedge risk in these market conditions. While I'm an experienced option trader and I know a lot about options, I'm not setting myself up as an expert, but rather as another option trader always learning and modifying my trading plans according to what I learn. In these articles, I'm inviting you along on the journey. I have freely admitted that in March, I deviated from my plan with disastrous results. A lot of options traders lost money in March, but I lost more than I should have lost. I had always rolled my iron condor spreads, making up the debit I would spend in closing out my original in-trouble spreads by rolling into more contracts. Due to several circumstances--market and illness-related circumstances--I was hit with a situation when I did not think it appropriate to roll into a higher number of contracts. That meant that I had to realize a loss I had thought I would never realize.

My quest since then has been to modify my trading plan so that unrealized losses never mount up to more than a preset maximum loss I plan before I ever get into the trade. That sounds so simple now, but I had been trading the same way for many years. I had been unwittingly skirting that same hole in my trading plan all those years without seeing the trap.

Both before and after that March event, I've been talking about hedging deltas. The deltas measure how big a profit or a loss your trade is going to experience if the price moves a certain amount. In a recent article, I talked about the fact that different traders and experts might hedge greater or lower amounts of deltas, depending on their preference, risk tolerance and market outlook. There's no one right way. I mentioned that I had said something to my broker about accidentally hedging too much when I had completely flattened deltas on a trade. He hadn't thought that was over hedging. Different people employ different practices and may vary those typical practices in different circumstances.

The question still remains, however: what delta value is so high or low (in the case of a negative delta) that it needs to be hedged, and how much hedging is appropriate? Of course, if we're in a directional trade, we want to benefit from price movement. We don't want flat deltas in a directional trade. We just don't want to lose too much if price moves the other way. In a trade such as an iron condor, we really would like those deltas to stay as flat as possible. We're not going to benefit from price movement away from the point at which we established the iron condor as much as we are going to be hurt by such a movement. Neither do we want to be constantly hedging to keep those deltas flattened because we'll be in dozens of little trades in and out, paying commissions each time. I recently read an article by Jared Woodard in the May issue of Expiring Monthly. Woodard laid out a methodology for determining the right amount of hedge. I thought his suggestion and another's might give our readers a guidepost they can incorporate in their own trading.

Woodard offered this suggestion for striking a balance. As a first step in making the determination, he suggested, a trader might look at a measure such as Average True Range (ATR), available on most charting platforms, and multiply that by the position deltas (p. 7). That will help a trader determine how much the position will profit or lose if the underlying moves the amount predicted by the ATR. Former market maker Dan Sheridan suggests using a one-day standard deviation for the same purpose. For example, imagine an SPX ATM straddle (long call and long put) has a position delta of 13.14, with position deltas shown somewhere on most brokerages' pages. Imagine that at the same time my rough calculation give me +/-14.92 points (dollars, in this case) as a standard deviation for the next day. If I multiplied the position delta by the standard deviation, I would come up with +/-$196.00. That would be the anticipated gain or loss for the next day if the SPX moved a normal standard deviation move either direction that day. Since the position delta had been positive, the trade would theoretically profited $196.00 if the SPX had moved up a standard deviation and theoretically lost $196.00 if the SPX had dropped a standard deviation.

Then Woodard suggests that the trader evaluate whether, if the move happened to be an adverse one, the trader would be comfortable with that amount of loss. That would depend on the size of the trader's account, the trader's risk tolerance and the size of the trade itself. Would it bring you to or past the maximum loss for the position? Sheridan suggests that you look at the loss as a ratio of the buying-power effect of the position, too. If you have a little IBM calendar that cost you a few hundred dollars, a loss of that magnitude is obviously going to matter more to the trade's outcome than if you have a $12,000 SPX straddle.

Of course, delta isn't the only Greek impacting the trade. A straddle is a theta-negative trade that's long vega. That means that it's going to be hurt by the passage of time (the theta-negative part) and benefit from a rise in volatility, so be sure to add in the effect that one day's time decay is going to have, too, adding to the potential loss and taking away some of the potential profit. A drop in volatility will also add to the loss while a rise in volatility will help plump up the position's value. A calendar is a theta-positive trade. It benefits from the passage of time, so an extra day's time is going to somewhat ameliorate any loss if it occurs.

Obviously, delta can't measure all the changes that are going to occur to the position, and Woodard himself mentions gap risk. Also, if we didn't know this previously, we know now that the SPX and other underlyings certainly can move around more than their average true range or a single standard deviation in a day. They can stretch a Bollinger band or otherwise move more than expected, even at the open. However, Woodard and Sheridan's suggestions do provide concrete ways we can measure how much risk is too much for our tolerance level. We can then take steps to ameliorate that risk or even close a position that's so close to maximum loss that a standard move the next day is going to move it way beyond that risk.