|Constructing a Delta-neutral strategy|
Trading in derivative products is largely viewed as speculative, and why not? When most position are built around just the ‘view’ of the trader. However, if the trader’s market outlook were faulty, the position would result in huge losses. A Delta-neutral strategy is a strategy by which you one make money without having to forecast the direction of the market.
The delta of an option is the rate of change in an option’s price relative to a one-unit change in the price of the underlying asset. So, for example, if a call option has a delta of 0.35 and the price increases by one Re, the option’s price should increase by 35 paise.
In the example above, the option has a delta of 0.35. Traders and brokers refer to that as “35 deltas.” Simply multiply the delta by 100 to make it a percentage. However, make sure you understand that “35 deltas” really means 0.35.
For the purpose of our discussion, whenever we mention the delta of an option, we are referring to the actual decimal value because that is what’s actually used in all mathematical models.
What exactly is Delta Neutral?
The term “Delta Neutral” refers to any strategy where the sum of your deltas is equal to zero. So, for instance, if you buy 10 call options, each having a delta of 0.60 and you also buy 20 put options, each having a delta of -0.30 you have the following:
…(10 x 0.60) + (20 x -0.30) = 6.00 + -6.00 = 0
Your position delta (total delta) is zero, which means you are delta neutral.
The technique you are about to learn, is just one application of delta neutral. It is a general trading approach that is used by some of the largest and most successful trading firms. It allows you to make money without having to forecast the direction of the market. You can use it on any market (stocks, futures, whatever), just as long as options are available and … the market is moving. It doesn’t matter whether or not the market is trending, but it won’t work if the market is really flat. The principle behind delta neutral is based upon the way an option’s delta changes as the option moves further into or out of the money.
Consider the following example:
You will notice the following characteristics of an option’s delta:
All of the deltas mentioned above assume that you are buying the options or the underlying asset, that is, you have a long position. If instead, you sold the options or the asset, establishing a short position, all of the deltas would be reversed. So, in the example above, if you sold a call option with a strike price of 100, and the price of the underlying asset was 110, the delta would be 0.9226 x -1 = -0.9226.
If you short the underlying, the delta would be -1.0 instead of +1.0.
Keeping all of this in mind, we can construct the following delta neutral trade:
How it works:
If the futures increase from 110 up to 112:
Profit = 2 x 2.00 = 4.00
The put options will decrease from 0.91 down to 0.28 (each)
Loss on put options = 5 x (0.91 – 0.28) = 5 x 0.63 = 3.15
Net profit = 4.00 – 3.15 = 0.85
If the futures price decreases from 110 down to 108:
Loss = 2 x 2.00 = 4.00
The put options will increase from 0.91 up to 2.14 (each)
Profit on put options = 5 x (2.14 – 0.91) = 5 x 1.23 = 6.15
Net profit = 6.15 – 4.00 = 2.15
We can summarize this delta neutral approach as follows:
If you buy the underlying and buy put options so your position is delta neutral:
If you sell (short) the underlying and buy call options so your position is delta neutral:
When you do this kind of delta neutral trading, you need to follow a few rules:
Keep an eye on the implied volatility of the options you’re using. If it moves toward the high end of its 2-year range, stay away from this position for a while. Otherwise, you might have excessive time decay in your options when the implied volatility starts to drop.
The options you buy should have at least 30-60 days remaining before expiration. Remember that time decay accelerates as the option’s expiration date approaches, so if you allow more time, you minimize the time decay.
As you have seen, these trade positions benefit by price movement in the underlying asset. It puts you in the enviable position of being able to take full advantage of big price moves, in any direction.