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A Delta Neutral Trade - Introducing a No Risk Option Strategy
Updated: Mar 15
What does it mean creating a delta neutral trade? Would like to make a profit either the market goes up or down?
Here is where delta neutral option strategies come to help! This trading tutorial introduces what we can call a no risk option strategy giving you an insight into the fundamental concept of delta.
A No Risk Option Strategy
Delta neutral option strategies are considered as those in which the direction of the trade is not important. This occurs because traders can gain the knowledge to manage their positions as to collect a profit either way the market moves.
Delta neutral traders must be able to find the optimal relationship among strikes, implied volatility and the effect of time decay. Their goal is to create positions with the highest probability of success regardless of the market direction.
As difficult it may sound, this is something anybody can do with patience and making a little bit of effort. You can achieve such result by planning and assessing in advance all possible reactions to market moves.
There are different types of delta neutral strategies:
Straddles (Long and Short);
Strangles (Long and Short);
Synthetics.
In this article, you will find information mainly related to straddles. More delta neutral strategies will be introduced and fully explained in following releases.
At this stage, there are two main truths in the stock market you must be aware of:
Stocks fluctuate all the time;
Time moves always on.
Accepting these two truths can help you choose options strategies that fit best your trading style and manage them in order to minimize the risk involved.
Delta Mechanics on Option Neutral Strategies
Creating a neutral option strategy imply putting together different options so as to hedge your overall position by making it delta 0.
To achieve this result it is necessary that you deeply understand what delta is and how it is calculated for stocks, options and futures.
Delta is a measure of how much the price of a financial instrument (stocks, options and futures) will change given a $1 change in the underlying. It is essential to know that stocks and futures have always delta equal to 1 if you are a buyer and -1 if you are a seller.
As a consequence, when you buy 100 stocks or one futures contract, you are +100 deltas; when you sell 100 stocks or one futures contract, you are -100 deltas.
Deltas are a little more complicated for options than they are for stocks and futures. For options, the delta is always a number between -1 and +1. Long options positions can only have positive delta, which is a number between 0 and +1, whilst short options positions can only have a negative delta, a number between -1 and 0.
The closer is the delta of options to 1 or -1; the highest will be the connection with the respective underlying security and, consequently, the impact of the stock movement on the option price.
The delta depends on the kind of options traded (calls or puts), the chosen strikes and the relationship with the price of the underlying. In other words, the delta of options is strictly related to the fact that options might be ATM (at-the-money), ITM (in-the-money) or OTM (out-of-the-money).
Such classification of options is known as option’s moneyness. On the basis of their moneyness options can be:
At-the-money (ATM); the options strike price of both calls and puts is at the closing price of the underlying or very close to it. In such a case, the delta will be around +.50 for long call options and -0.50 for long put options.
In-the-money (ITM); the strike price of call options is below the closing price of the underlying, while the strike price of put options is above the closing price. ITM long call options will have deltas between +0.50 and 1, while ITM long put options will have deltas between -0.50 and -1.
Out-of-the-money (OTM); the strike price of call options is above the closing price of the underlying, while the strike price of put options is below that some closing price. OTM long call options will have deltas between 0 and +0.50, while OTM long put options will have deltas between -0.50 and 0.
In the case of short calls and puts, ITM and OTM values will be absolutely in the other way around:
ITM short call options will have deltas between -0.50 and -1, while ITM long put options will have deltas between +0.50 and 1.
OTM short call options will have deltas between 0 and -0.50, while OTM short put options will have deltas between 0 and +0.50.
Setting up a Delta Neutral Trade
Let's try to create together a delta neutral strategy. If you buy 100 shares of stock, you will be positive 100 deltas (+100). As your purpose is to get a delta 0 position, you need to find financial instruments which carry -100 deltas.
You can decide to buy two ATM put options or to short two ATM call options (ATM puts have something in the region of -0.50 deltas, while ATM calls something in the region of +0.50 deltas).
As each option’s contract gives the right to control 100 shares, you will have roughly -100 deltas and your position will be balanced.
In analytics terms, there may be four scenarios:
Scenario 1 - Long stocks and puts
Buy 100 stocks +100 deltas
Buy 2 ATM puts (-0.50*2)*100= -100 deltas
Scenario 2 - Long stocks and short calls
Buy 100 stocks +100 deltas
Sell 2 ATM calls (-0.50*2)*100= -100 deltas
Scenario 3 - Short stocks and long calls
Sell 100 stocks -100 deltas
Buy 2 ATM calls (+0.50*2)*100= 100 deltas
Scenario 4 - long puts and calls
Buy 2 ATM calls (+0.50*2)*100= +100 deltas
Buy 2 ATM puts (-0.50*2)*100= -100 deltas
As you may notice in the fourth scenario, a long straddle involves buying the same number of contracts of ATM calls and puts. In a delta neutral strategy, it is very important to keep the delta as much close to 0 as possible in order not to be influenced by the stock direction.
Once into the trade, if the underlying start moving far from the entry point making your overall delta position positive or negative, you may need to carefully adjust your position in order to keep it delta neutral and not be affected by the market direction.
As a rule of thumb, a straddle is required to be delta neutral not only when the position is open, but also throughout the trade and until a certain and awaited catalyst event (e.g. earnings release) occurs.
