What is Delta Neutral Trading?

If you want to upgrade your trading level, gain consistency, and become long-term profitable, you have to move for this type of trading. My trading style is essentially this type of trading where I apply my proprietary options strategies to the Hedge Fund I am managing.

Last couple of weeks we discussed the importance of Implied Volatility in options pricing because the majority of beginner options traders fail to understand it and how important is volatility and how it can be used to our advantage.

The majority of beginner traders are options buyers and miss out on the chance to profit from high volatility declines. This type of trading strategy is called Delta Neutral. One book that I can suggest that explores this concept is “Option Volatility and Pricing” by Sheldon Natemberg. A must-read if you want to move your trading into the next level.

Delta Neutral trading can be used to explore extremes in volatility. The goal is to enter a position that starts in a Delta Neutral (Delta near 0) state and adjust accordingly as long as underlying moves to maintain Delta neutrality. Please bear in mind that not only when the underlying price moves impact Delta, but also when there is an IV change or time passes. If we keep Delta under low value and Volatility changes according to our predictions we end up gaining money from this type of trade. 

For example, if we are under a low IV environment and we anticipate a market move down in a certain stock which will cause a spike in IV, we can buy an ATM (at-the-money) Straddle. This strategy involves buying a Call and a Put at 0.50 and -0.50 Deltas (or at the strike price equal to market price) that both neutralize each other and the position will gain if market moves in either direction and/or if there is an increase in volatility. By then, if Delta of the option position becomes, for example, at -10, we can buy 10 shares or buy 1 Call at 0.10 Deltas to turn our overall Delta close to 0 again (become Delta Neutral). 

But now, you may comment that this should not be so simple. Indeed, it is not so easy because with options everything varies and one key issue is time value! As time passes, in the given example, we are buying options, and hence the position will lose money due to options time decay. The strategy described above included only long options that will produce high negative Theta!  If the increase in volatility is not fast enough, the position will lose from time decay even if there were an increase in options volatility. 

 

Delta neutral strategies are options strategies that are designed to create positions that aren't likely to be affected by small movements in the price of a security. This is achieved by ensuring that the overall delta value of a position is as close to zero as possible.

Delta value is one of the Greeks that affect how the price of an option changes. We touch on the basics of this value below, but we would strongly recommend that you read the page on Options Delta if you aren't already familiar with how it works.

Strategies that involve creating a delta neutral position are typically used for one of three main purposes. They can be used to profit from time decay, or from volatility, or they can be used to hedge an existing position and protect it against small price movements. On this page we explain about them in more detail and provide further information on how exactly how they can be used.

 

 

Basics of Delta Values & Delta Neutral Positions

The delta value of an option tells you how sensitive it is to small changes in the price of the stock. A high delta indicates that the options' price moves very little when the stock price fluctuates. A low delta indicates that the options price moves a lot when the market fluctuates around the strike price.

A delta neutral position is one where the option position does not move much regardless of what happens in the price; therefore, the option is considered to be fairly insensitive to price fluctuations if the stock.

An investor can use the delta value to determine whether he or she wants to buy or sell options (strike price selection). Options with a lower delta value are less likely to move in response to movement in the stock price. Therefore, investors who want to profit from rising prices in the stock tend to avoid buying options at a certain strike price with a low delta. Conversely, investors looking to profit from falling stocks might prefer to invest in options with a high delta because those options are less likely to fall in value when the stock falls.

 

The effects of time decay are negative when you are long in an options position, because their extrinsic value will decrease as the expiration date gets nearer. This can potentially erode any profits that you make from the intrinsic value increase. However, when you write an options contract at a certain strike price, time decay becomes positive, which is a good thing to happen. In these cases, we say the option strategy is an income trade.

By writing options to create a delta-neutral position, you can benefit from the effects of time decay and not lose any money from small price movements in the stock. Nevertheless, for any option position there is always some risk of loss for certain price intervals.

The simplest way to create such a position to profit from time decay is to write at the money calls and write an equal number of at the money puts based on the same security. Basically, you chose a strike price near the current stock price. The delta value of at the money calls will typically be around 0.5, and for at the money puts it will typically be around -0.5.

 

Implied Volatility is an important factor to consider in options trading because the prices of options are directly affected by it. A stock with higher volatility will have either had large price swings or is expected to, and options based on a security with high implied volatility will be more expensive (even for a given strike price and the same expiration). Those based on a security with low volatility will usually be cheaper A good way to potentially profit from volatility is to create a delta neutral position on a security that you believe is likely to increase in volatility. The simplest way to do this is to buy at the money calls on that security and buy an equal amount of at the money puts. This strategy does require an upfront investment, and you stand to lose that investment if the contracts bought expire worthless or the implied volatility levels start to decrease or the time passage erodes the options premium. However, you also stand to make some profits if the underlying security enters a period of volatility and moved away, regardless of direction, fast from the initial price (in the example the strike prices that were used to open the position).

If it goes up substantially, then you will make money from your calls. If it goes down substantially, then you will make money from your puts.

An options position could be hedged with options exhibiting a delta that is opposite to that of the current options holding to maintain a delta neutral position. A delta neutral position is one in which the overall delta is zero, which minimizes the options' price movements in relation to the underlying stock. Across the option chain, each strike price will have a certain amount of deltas.

For example, assume an investor holds one call option with a delta of 0.50, which indicates the option strike price is at-the-money and wishes to maintain a delta neutral position. The investor could purchase an at-the-money (at the same strike price) put option with a delta of -0.50 to offset the positive delta, which would make the position have a delta of zero in a given time period.

When the stock price starts to move, delta will vary. It is on the trader side to chase the best adjustment possible to return again the options position to its delta neutrality. At the new current price, the trader will choose the option (or option strategy) that will best position the Greeks at its goals. 

Another way to understand deltas and how to adjust is to use shares of stock. If a certain position presents -10 deltas, if you want to adjust to its delta neutrality using shares, you could simply buy 10 shares of stock.

 

 

For the ones that are following me, you are now concluding all my options strategies are Delta Neutral. Indeed, I have this trading style when trading options. Examples of my proprietary strategies include the Ride Trade, the SPX Best Trade, the Pro Iron Condor, SPY Speed trade, to name the main strategies I trade live. All of them are Delta Neutral strategies. But a different kind of Delta Neutral strategy that explores not only Volatility changes but is also hedged to Theta!  In fact, that strategy produces a positive Theta and we are not stressed about losing money with options time decay. It captures value from time decay because it involves selling options.

Additionally, all the adjustments made take into consideration not only Delta adjustments but also minimizing Theta impact, maintaining it as much positive as possible! For example, the Ride Trade solved the problem being Delta Neutral and gaining from time passing. Even, being Vega positive, it can profit in a decaying volatility environment due to a time premium that will compensate for it! 

But now, you are thinking that "Ride Trade" is the perfect trade! No, it isn't! There is no such trade! There are circumstances where it does not produce profits,  For example, if there is a  fast decrease in IV (with a fast market movement up on SPY or QQQ) just after the trade is entered whenTheta is still low. That is why we can have other strategies we can combine with VXX to offset the potential losses