Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

Constructing a Delta-neutral strategy

4 min read

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:

Statistical Volatility 25%
Option Strike Price 100
Days remaining 30

 

Price of underlying Call Option Put Option Delta of underlying
80 0.0013 -0.9987 1.0000
85 0.0148 -0.9852 1.0000
90 0.0843 -0.9157 1.0000
95 0.2668 -0.7332 1.0000
100 0.5371 -0.4629 1.0000
105 0.7805 -0.2195 1.0000
110 0.9226 -0.0774 1.0000
115 0.9795 -0.0205 1.0000
120 0.9958 -0.0042 1.0000

You will notice the following characteristics of an option’s delta:

  • The absolute value of the delta increases as the option goes further in-the-money and decreases as the option goes out-of-the-money.
  • At-the-money call and put options have a delta that is right around 0.50 and -0.50 respectively.
  • Put options have a negative delta, which means if the price of an asset goes up, the price of a put option on that asset goes down.
  • Deep in-the-money call options have a delta that approaches +1.00. Conversely, deep in-the-money put options have a delta that approaches -1.00.
  • Deep out-of-the-money calls and puts have deltas that approach zero.
  • The delta of the underlying asset itself always remains constant at 1.00.

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:

Stock futures price 110
Statistical Volatility 8%
Option Strike Price 110
Days remaining 30

 

Price of underlying Option Theoretical price Option delta
108 2.14 -0.73
109 1.43 -0.58
110 0.91 -0.42
111 0.53 -0.28
112 0.28 -0.16
  • Buy 2 stock futures at 110
  • Buy 5 put options (110 strike price) at 0.91 each
Delta of futures 2 x 1.00 = -2.00
Delta of put options 5 x -0.42 = -2.10
Total position delta 2.00 + -2.10 = -0.10

 

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:

  • When the market goes up, you have a profit on the underlying and you have a smaller loss on the options (because their delta decreased), so you wind up with a net profit.
  • When the market goes down, you have a loss on the underlying but you have a bigger profit on the options (because their delta increased), so again you have a net profit.

 

 

If you sell (short) the underlying and buy call options so your position is delta neutral:

  • When the market goes up, you have a loss on the underlying but again you have a bigger profit on the options (their delta increased), so you have a net profit.
  • When the market goes down, you have a profit on the underlying but once again, you have a smaller loss on the options (their delta decreased), so you still have a net profit.

 When you do this kind of delta neutral trading, you need to follow a few rules:

  • Always initiate the position with a total position delta of zero or as close to zero as possible. So, your starting position is “delta neutral.”
  • When the market moves enough so your total position delta has increased or decreased by at least +1.00 or -1.00 delta (or more), you make an “adjustment” by buying or selling more of the underlying asset to get your position back to delta neutral. You can also sell off some of your options to get back to delta neutral. But the point is, you make profits consistently by making these adjustments.
  • If the price of the underlying asset doesn’t move around much, close out the entire position. You need some price action for this approach to work. If the market just sits there, time decay will eat away at this position.

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.

 

Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

Risk Management is only for the Poors – Game…

Game Stop Corporation a brick and motor video game retailer is been in the limelight for the last few days and thanks to Robinhood...
Rajandran R
2 min read

Investors are Dumb?

Last Thursday Elon Musk (Tesla CEO) urged his Twitter followers to use Signal App instead of Whatsapp over privacy issues. Elon Musk tweeted after...
Rajandran R
1 min read

Ultimate Guide to Momentum Trading

This a brief video guide for the momentum traders which explains right from what is momentum trading ,how momentum trading is related to diffusion...
Rajandran R
18 sec read

12 Replies to “Constructing a Delta-neutral strategy”

  1. dear rajendran,

    u r doing v good job. thanks and wish u all success in yr life.

    I need to know the afl code for stock d & k as mentioned in the 5 day chart. if u can send me that by my email pravin1535@yahoo.co.in

    thanks in advance
    pravin
    mob 9979471784

  2. Sir Please Constructing Delta-neutral strategy on NIFTY FUTUR with Example.
    Rajandran sir I need to know delta-neutral strategy and example with NIFTY FUTURE please send me on my email.

  3. When Delta Neutral Position is created, then your Position of delta is zero. So how to make profit out of it?

  4. I did paper trading today to see what you mentioned above is right. But it did not follow so. Here is the data. Nifty Fut was 7650 @ 12 noon on 7/8/14 and the 7650 PE was 88.50 with a Delta of -0.43. When the nifty future moved to 7669 @ 13.30 Pm today, the 7650 PE fell down to 76.10. So calc. would be as follows;

    1. Nifty Future profit – 7669 – 7650 = Rs. 19 Profit * (1 lot or 50 shares) = Rs. 850/= Profit
    2. 7650 PE Loss – 76.10-88.85 = Rs.12.75 Loss * (2 lots of Nifty to neutralize delta) = Rs. 1275/= Loss
    3 Net loss = Rs. 425/ =

    Please comment.

  5. Uday, This delta neutral strategy is positional and you need to hold for few days. this is definitely not for 90 ( 12.00 to 1.30) minutes trading. you need to stay calm for few days then the time volatility will automatically reduce the premium of Option and then you will start seeing PROFITS. Prasanna.

  6. I am planning to trade in nifty options from next month using Delta Neutral Strategy. But instead of Shorting any option at some strike price and buying the same at another strike price, I am planning to short both put and call options. For example if Nifty is trading at 8300 I will sell put option at strike price say 7900/7800 and also sell call option at strike price say 8700/8800 and try to earn full premium amount at the time of expiry assuming hopefully that nifty doesn’t cross either strike price. Please tell me will this strategy work? Also inform me what precautions should I take?

    1. Hi MukesSabharwalh,
      If I’m not wrong this sound like Short Strangle. Of course it works.
      High Implied Volatility is good when initiating Short Strangle Trades
      and Timedecay is your friend….

      huge risk on both sides (if underlying makes a big moves).

      Instead prefer IronCondor.

      Mahender

  7. Dear Sir,

    I want to know how to protect my sell option. I am comfortable with option selling . So if i sort any call option with delta less than 0.5 then how i can protect my loss in case the underlying increases and due to that delta increases . I want to know about strategy to minimise my risk with put sell and future call . Looking forward for your response.I have seen your description above but not able to formulate. So request you to please explain as mentioned in my subject.

    Regards

    Nitesh Kumar

  8. Sir how would it be good if I short in the money put and call options. like if market is 9300 I will sell 10000 put and 8600 call. what happens till expiry in different situations. Waiting for your fast reply sir.

Leave a Reply

Get Notifications, Alerts on Market Updates, Trading Tools, Automation & More