Having options in the game of life is generally considered a positive strategic position.
The same can be said for financial options in the trading world. The introduction of optionality into a portfolio can provide flexibility and strength. Options can be used to take directional risk, to hedge directional risk, or as a play on volatility.
One important thing to remember is that when using options to trade volatility, there remains a delta component to the trade. Most volatility-based options positions will perform better to one direction, as compared to the other.
“Delta neutral” trading when used in conjunction with a volatility strategy is an approach that seeks to minimize the “delta” component of a volatility trade to the greatest degree possible.
When an options trade is hedged “delta neutral,” it’s said to be a more of a pure play on volatility, as opposed to direction.
As a review, delta is one of the four main risk measures in the world of options that in sum are often referred to as “The Greeks.” This nickname came about due to the inclusion of Greek variables in the original Black-Scholes Model.
Delta can be a particularly confusing “Greek” because it can be referenced in a variety of ways in the options universe.
As a “Greek” in Black-Scholes terms, delta tells us how much the price of an option will fluctuate for every $1 move in the underlying price of the stock. If an option has a delta of .60, that means that for every $1 move in the underlying, the price of the option will move $0.60.
“Delta” may also be used (more loosely) when referencing the probability that an option finishes in-the-money (ITM). Consequently, an option with a .50 delta would be thought to have a 50/50 chance of finishing ITM.
However, delta has yet another interpretation/application that is typically referred to as the “hedge ratio” - which relates directly to “delta neutral” trading. The hedge ratio is used to calculate the number of underlying shares that are needed to hedge a volatility-based options trade.
For example, if you sell a call, your primary risk is that the stock rises through the strike you have sold and ultimately goes higher than your upside breakeven. Therefore, by purchasing stock against the call you have sold, you can limit your risk if the direction of the stock goes against you.
Taking a practical example, consider that you’ve sold 100 contracts in a .40 delta call of stock XYZ. Applying the hedge ratio to this trade, a trader would purchase 4000 shares of XYZ (100 x .40 x 100) to establish a delta neutral position. The calculation can be broken down into - number of contracts multiplied by the delta of the option multiplied by the equity option multiplier (100).
If you take the time to really understand the difference between selling 100 contracts naked, as compared to the “delta-neutral” approach described above, it becomes easier to understand the different risk profiles of each approach, and why the latter is more geared toward volatility.
If a trader is bearish XYZ, it’s certainly possible that he/she might decide to purchase fewer shares against the sale of 100 contracts in XYZ - in order to express that view. An adjustment such as this would consequently increase the upside risk of the position.
Spread trades can also be executed in a “delta neutral” fashion - meaning that directional risk from a spread trade can hedged away using shares of the underlying. Many spreads (especially straddles and strangles) can even be executed delta neutral without an underlying hedge (particularly at the outset of the position).
If you sell a call and put with the same delta, then these two positions offset to create a delta neutral spread. A recent episode of Options Jive specifically covers delta neutral spread trading and compares this approach to spread positions that require a hedge in the underlying at the outset of the trade.
If you're interested in learning more about delta neutral trading we recommend reviewing the entire episode referenced above as well as a previous installment of Market Measures that focuses on the same subject.
In review, the general goal of delta neutral trading is to “mute” directional exposure, with the intent of isolating the volatility component of the trade.
Depending on your strategic approach and risk profile, delta neutral trading may represent a practical way of reducing risk in your portfolio - especially if your goal is to take advantage of mean reversion in the volatility space.
We’ll be following up with future blog posts on this topic, but in the meantime, we hope you’ll reach out at firstname.lastname@example.org with any questions or comments.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.