Options, in contrast, have variable deltas that change as the underlying price moves

Increasing Your Profits with Adjustments

You can create the best trade in the world, but what you do after the trade is placed is crucial to your success. When you put on a trade that is perfectly delta neutral and the market makes a move, it

changes your overall position delta. Your trade is no longer delta neutral. At this point, you can choose to maintain or exit the trade, or return to delta neutral by making adjustments. To bring a trade back to delta neutral (a position delta of zero), an adjustment can be made by purchasing or selling options and stocks (or futures) to offset your position. Determining which adjustment to make is a decision dependent on analysis and market experience.

In general, when delta neutral trading guides your decision-making process, you know when and how to make an adjustment to your position. To a certain extent, adjustments are the real meat of delta neutral trading. As you become more experienced with this process, your profits will reflect your increased proficiency. This is where the professional floor trader needs to excel to survive. Off-floor traders have more time to think about and execute the optimal hedge.

When you are trading delta neutral, it can be helpful to think of one side of the trade as your hedge and the other side as your directional bet. In many cases, even if you are 100 percent wrong about market direction you can still make a profit. I prefer to hedge with the options and bet on the direction of the stock (or the futures). Theoretically speaking, if the market moves 10 points up or down, you should be able to squeeze the same amount of profit out of the trade. However, when you start factoring in things like time decay and volatility, this figure may change. For that reason, the trader will often adjust the position in order to shift back to neutral. Lets consider some examples.

VARIABLE DELTAS

Before we show some working examples of adjustments, keep in mind that there are two types of deltas: fixed deltas and variable deltas. A fixed delta means something that never changes, something that always stays the same. For example, if you buy 100 shares of XYZ selling at $25 per share and then sell it for $30, you will have 5 points deposited into your account, or $500. Conversely, if you buy 100 shares at $25 a share and it goes down to $20, you lose 5 points$500 will be drained out of your brokerage account. Either way, the delta of the shares remains the same. This is a fixed delta. Buying and selling futures is also an example of fixed deltas. The deltas will remain at +100 for each 100 shares of stock you are long and -100 for every 100 shares you short sell.

What is a variable delta? Deltas change because of the passing of time and due to market movement, which also changes prices. Options at different strikes have different deltas that vary as the underlying security changes.

If you buy 500 shares and sell 500 shares at $25 per share, your overall position is delta neutral. But theres something faulty in this reasoning. This kind of trade goes flat. Although this combination creates an overall position delta of zero, since both deltas are fixed, this trade cannot be adjusted, and will not increase or decrease in value. Options, in contrast, have variable deltas that change as the underlying price moves. When the overall position delta moves away from zero, you can apply adjustments to bring the trade back to delta neutral and thereby generate additional profits.

As we have already discussed, delta is at the cornerstone of learning delta neutral trading. As previously shown, one future or 100 shares of stock has a fixed delta of plus or minus 100 while ATM options have a delta of plus or minus 50. If you buy 200 shares and get a delta of +200, you can buy four ATM puts or sell four ATM calls to create a delta neutral trade: 200 + (4 — 50) = 0. The type of options you choose determines whether the position has a long or a short focus. The plus or minus sign of the delta depends on which direction best takes advantage of the market circumstances. Buying a call or selling a put takes advantage of a rising market and therefore has a corresponding plus sign. Buying a put or selling a call takes advantage of a decreasing market and therefore has a minus sign.

Mathematically, this is quite easy to understand. But why do deltas act the way they do? Perhaps a simple analogy will convey the meaning of a delta. When you slam on the brakes of your car, the process from the time you hit the brakes until the time your car stops is like a delta curve. Near the end of the stopping, you tend to experience more deceleration than when you first hit the brakeseven with antilock brakes. Right at the precise point where you completely stop, everybody kind of jogs forward a bit for a little whiplash action. This is exactly like the movement of a delta at expiration.

ADJUSTING A STRADDLE

One of the advantages of trading straddles is the ability to easily adjust them. The adjustment process is designed to bring in additional profits while maintaining the delta neutral status of the trade. The adjustment strategy used depends on a wide variety of trade specifics. This chapter is designed to explore the reasons why adjustments are an effective trading tool. A delta neutral trade is one in which the overall delta of the combined position equals zero. This means that both sides of a delta neutral trade balance each other out, thereby reducing the overall risk of the trade. The trade makes money when one leg of the trade moves in-the-money enough to pay for the cost of placing the overall trade.

Straddles and strangles are nondirectional delta neutral trades that rely on increases and decreases in volatility movement to make a profit. Straddles use ATM options with identical strike prices and expiration dates. A long straddle is usually applied in markets where a large price movement is anticipated; but the direction of the move is unclear. Upon entering a straddle, the underlying stock price changes to some degree in one direction or the other. As the price fluctuates, the position is no longer delta neutral. An increase in the underlying stock price creates a positive delta, and a decrease creates a negative delta. The trade thereby changes its nature to becoming either bullish or bearish, and the resulting profit becomes more reliant on the future direction of the underlying stock.

Lets look at an example to see how an adjustment can change this scenario. If youre holding a straddle and the price of the underlying stock rises, the delta becomes positive and you have a profit on the call side of the position. At this point you may not want to lose the profit you already have, so you have three choices:

1. Close the position, take your profits and move on. Although this may be

the most prudent move to make, you can no longer participate in any future moves. You have put a limit on your gains, as well as your losses.

2. Sit tight and do nothing. Just continue the trade, hoping the price

will continue to rise and your profits will increase. If the price goes up, the trade is a winner. If the stock takes a nosedive, you are risking your profits. If the price of the stock declines, you may lose your profits, and perhaps some of the original premium due to time decay.

3. Adjust the position. There are several ways to do this. The idea is to

continue in the trade while simultaneously capturing profits and returning the overall position delta to zero.

These three alternatives possess their own respective advantages and disadvantages. Often the best choice can only be determined by hindsight. But since the key to profitable trading lies in assessing the available choices, learning the benefits of adjusting can help you to become a more profitable trader.

Options with various strikes have different deltas, and these delta amounts change as the underlying assets price fluctuates. The object of the delta neutral game is to keep your trade as close to zero deltas as possible. When the next uptick changes the market you are trading, you are no longer neutral. That means that you may be able to make an adjustment by purchasing or selling calls, puts, or stock shares to get the trade back to delta neutral.

Adjustments are much easier to make when you have placed a trade with multiple contracts. They enable traders to lower the overall risk of the trade, and in some cases, start the spread over again at a new price. If theres a profit on the table, an adjustment can allow you to take it and still keep the overall risk of a trade low. If the price continues to rise, you can still benefit from the bullish movement. Conversely, if the price declines, there are ways to profit from a reversal rather than lose. As a delta neutral trader, I have often found it profitable to adjust my straddle positions.

Since a straddle is already a combination trade consisting of at-themoney (ATM) puts and calls, there are many alternatives by which adjustments can be made. All adjustments, however, fit into two categories: adjusting with options or stock. The adjustments further break down into positive or negative changes depending on what is needed to bring position delta back to zero.

Adjusting with Options

Straddles have a large theta risk because the time value of the options is constantly declining, which results in lost premium. Since adding more options increases the theta decay, you can decrease it by making adjustments through selling options that are already owned. If the price of the stock has increased since the last adjustment, you can reduce the delta by selling some of the calls and taking profits. If the price of the stock declines, simply sell some puts to increase the overall position delta. Selling options provides an additional major advantage: You can put your cash back to work by investing in new positions.

The number of options to be sold depends on the overall position delta in relation to the deltas of the specific options. All options are provided a delta relative to the 100 deltas of the underlying security. If 100 shares of stock are equal to 100 deltas, then the corresponding options must have delta values of less than 100. You can estimate an options delta using Table B.3 in Appendix B.

Selling options does have two basic disadvantages: commissions and slippage. Most traders pay a certain minimum commission when trading optionstypically $10 to $30. If the adjustment involves the sale of only one or two options, this can become a significant amount. In addition, the bid/ask spread on options is an eighth or higher, sometimes as much as a whole point. This can also have a detrimental effect on the profitability of the position. Since you are working with a spread, it can be difficult to be precise with adjustments because the calculations involved in trying to pinpoint the price at which the contract should be sold are often problematic.

Adjusting with Stock

Adjusting a straddle with stock is a fairly easy to understand process and usually less difficult to execute. If the straddle becomes too delta positive (long), shares of stock can be sold. If the straddle becomes too short, stock can be purchased to easily adjust the delta. The calculations of when to make an adjustment are much easier: When delta gets to 100, a sale of 100 shares of stock will bring it back to zero.

Commissions on buying and selling stocks have become so low, thanks to the advent of online brokerages, as to hardly be of any concern. Many online brokers will execute a trade for less than $10. The bid-ask spread is typically a sixteenth and the savvy trader can get a price executed exactly when the trader wants.

Although selling options might appear at first to be the best way to make adjustments, for the reasons just mentioned, many traders have found that adjusting with stock is the most efficient way. Option software and spreadsheets can be produced that can very easily indicate all of the possible adjustments needed in the trading day, before the market opens.

Adjustment Targets

There are three main triggers or targets that you might consider using to make adjustments in a spread position: delta-based, time-based, and event-based targets. Each one has a unique set of advantages and disadvantages that can be employed to advance your profitability.

Delta-Based Adjustments The straddle is constantly monitored for its position delta. Using option software, you can watch how the price of the stock changes, which triggers market makers to change implied volatility. In the process, the delta of your position is recalculated. When the delta reaches a predetermined levelusually 100you can adjust the position by buying or selling stock or options to return it to delta neutral. Many traders do their calculations at the beginning of each day, identifying the exact stock prices at which the delta will change by 100, and place orders to buy or sell stock at that point. This allows the orders to be placed in advance and automatically executed at the proper levels. The trader does not have to follow the stock tick-by-tick to find the adjustments; they will just happen.

The major advantage of this method is that it is exact and mechanical. The position never acquires more than plus or minus 100 deltas, thereby capturing profits as they occur. You can also take advantage of intraday swings in price. No judgment or decisions are necessary because the adjustments are automatic.

The main disadvantage used to be the time it took to do the calculations. But technology rules the day. This process can be computerized into a spreadsheet, even the number of trades that are made and the resulting commissions. But another disadvantage rears its ugly head: Delta-based electronic trading does not allow for positions to spontaneously run or take advantage of the higher deltas from a large move in the stock. This, however, is the type of directional risk that we are seeking to avoid.

Time-Based Adjustments A simple method is to make delta adjustments according to a time schedule. At the end of the morning, the day, or the week, a calculation is made to bring the position back to delta neutral. The major advantage is simplicity, but many opportunities for adjustments between the scheduled times might be missed.

Event-Based Adjustments This method is used quite frequently to adjust positions that would not ordinarily be adjusted. A special event makes such an adjustment important in preserving profits.

For example, the release of an earnings report increases a stocks market volatility. In fact, stock prices often run up or down in anticipation of the upcoming report, and if the report catches Wall Street by surprise, the stock might reverse direction altogether. In this case, just before the report, an adjustment can be made to capture the profits in the straddle that have resulted from the preannouncement volatility increase and resulting move in the stock. By returning the straddle to delta neutral, you can benefit from a continued run, or even more important, from the reversal that seems to occur frequently around these reports.

For example, lets say you have a straddle on a stock, with a strike of 50. The earnings report will be on Monday, and the stock has moved to 60 in anticipation of a great report. You could choose to be optimistic and hope that the report will be a surprise to the upside, and the stock will increase even more. But what if the report triggers a sell-off? Youll lose your profits. If you do your delta calculationssell some stock or options to bring the position back to delta neutralby Monday you wont care which way the stock moves; you will benefit either way!

Bottom line: Adjustments can be excellent ways to reduce your risk of losing hard-earned profits, and even increase them further by benefiting from reversals.