Delta neutral trading is a common technique among professional options traders. The delta of an option is the degree to which a derivative follows the stock or underlying. This delta is a number between -1, and 1, and represents a percentage. A delta with negative one equates to a negative correlation between the underlying and its derivative. A delta with positive one equals a positive correlation between the underlying and its derivative.

The concept of delta neutrality really applies to trading a portfolio of options or better yet as a market maker. You can benefit from delta neutral trading if you trade more than one option at a time. This is how to produce a delta neutral portfolio: first check the delta of each option then summarily add them up based on proportion of each option in the portfolio.

Example

For example, say we have five options in the portfolio, each with one fifth of the capital allocated to each option. Also, say that the delta for each option is as follows: 0.2,0.3,0.4,0.5,0.6. In other words, each option with 20% capital allocated to each has deltas equal to 20%,30%,40%,50%, and 60%. To sum up the portfolio’s total delta we would multiply as such; 0.2*(1/5)+0.3*(1/5)+0.4*(1/5)+0.5*(1/5)+0.6*(1/5)=0.40 the result equals 40% delta.

In order to make this delta neutral we could simply sell a call option with a 40% delta, or buy a put option with a negative 40% delta. This, in turn, would make the entire portfolio have a delta equaling zero. This is what’s known as delta neutral. When the portfolio is delta neutral, no matter what the underlying stock or market does, the portfolio would not make or lose money. It would be perfectly hedged.

Although no portfolio can be perfectly hedged; a constant adjusting and realigning of the portfolio delta will help to minimize the exposure of the portfolio. The costs of purchasing and trading of options can quickly become exorbitant, make sure that you have a good commission structure for this type of professional trading.

Although delta neutral trading is a technique mostly used and refined by market makers, knowing how it works will give you an intermediate understanding of how to approach the markets when trading options from the standpoint of risk management.

Managing risk

Risk management is understanding how to plan for risk before the trade, how to limit risk during the trade,and how to stop losses short in ending the trade. Understanding delta, and delta neutral trading, will help you limit risk when trading options. It’s important to be actively involved and constantly monitoring the trade.

Also, when applying delta neutral trading techniques you should know what’s known as a fix-it trade. A fix-it trade minimizes delta exposure by opening a second option position, while keeping the original position open. This usually occurs when the original option position has failed quickly leaving a poor prospect for future profits. Knowing a little about delta neutral trading makes the fix-it trade a good complement to your arsenal of techniques.

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