Delta Neutral Trading — Definition

An option position which is relatively insensitive to small price movements of the underlying stock due to having near zero or zero delta value.

Delta Neutral Trading — In Layman Terms

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Delta Neutral Trading and Delta Neutral Hedging are only for option traders who wants completely no directional risk nor bias. Delta neutral hedging not only removes small directional risks but it is also capable of making a profit on an explosive upside or downside breakout if a position’s gamma value is kept positive. As such, delta neutral hedging is also great for uncertain stocks that are expected to make huge breakouts in either direction.

Delta Neutral Trading — Terms And Jargon

An option contract with 0.5 delta value is referred to as having 50 deltas (each contract represents 100 stocks, so 0.5 x 100 = 50).

All else equal and disregarding volatility, being long 100 deltas means that if the underlying stock moves up by $1, the position gains $100 and if the stock moves down by $1, the position loses $100. A position that is long 50 deltas means that if the underlying stock moves up by $1, the position gains $50 and if the stock moves down by $1, the position loses $50. Being delta neutral or 0 delta, means that the position value neither goes up nor down with the underlying stock. Understanding delta is therefore the most important fundamental option trading knowledge.

There are 2 forms of delta neutral hedging, known as Static Delta Hedging and Dynamic Delta Hedging. Static Delta Hedging means setting a position to zero delta and then leave it to unwind on its own. Dynamic Delta Hedging is to continuously resetting the delta of a position to zero.

Delta Neutral Trading — Option Only Example

An At The Money (ATM) call option has a delta value of 0.5 and an ATM put option also has a delta value of -0.5. Buying both the call option and put option results in a delta neutral position with 0 delta value.

0.5 (call option) — 0.5 (put option) = 0 Delta

Buying both the call option and put option at the same at the money strike price is a popular delta neutral option trading strategy, called a Long Straddle. profiting when the underlying stock moves up or down significantly.

Delta Neutral Trading — Option + Stock Example

A share has a delta value of 1 as it’s value rises by $1 for every $1 rise in the stock. If you own 100 shares of a stock, you can attain a delta neutral position by buying 2 contracts of it’s at the money put options with delta value of -50 per contract.

100 (delta value of 100 shares) — 100 (2 x 50) = 0 Delta

Any small drop in the price of the shares will be instantly offset by a rise in the value of the put options. Any small rise in the price of the shares will also be offset by a drop in the value of the put options. This is an extremely popular option trading technique used by option traders who owns shares to protect the value of that position when the stock reaches a strong resistance level.

Delta Neutral Trading — Purpose

There are 2 purposes for going delta neutral on a position and are favorite option trading techniques of veteran or institutional option traders. I call them Delta Neutral Trading and Delta Neutral Hedging.

1. Delta Neutral Trading — To Make A Profit

Delta Neutral Trading is capable of making a profit without taking any directional risk. This means that a delta neutral trading position can profit when the underlying stock stays stagnant or when the underlying stock rallies or ditches strongly. This is fulfilled in 4 ways.

1. By the bid ask spread of the option. This is a technique only option trading market makers can execute, which is simply buying at the bid price and simultaneously selling at the ask price, creating a net delta zero transaction and profiting from the bid/ask spread with no directional risk at all. This is also known as Scalping.

2. By time decay. When a position is delta neutral, having 0 delta value, it is not affected by small movements made by the underlying stock, but it is still affected by time decay as the premium value of the options involved continue to decay. An option trading position can be set up to take advantage of this time decay and one such example is the Short Straddle which profits if the underlying stock remains stagnant or moves up and down insignificantly.

3. By Volatility. By executing a delta neutral position, one can profit from a change in volatility with no directional risk when the underlying stock moves insignificantly. This option trading strategy is extremely useful when implied volatility is expected to change drastically soon.

4. By creating volatile option trading strategies. Even though delta neutral positions are not affected by small changes in the underlying stock, it can still profit from large, significant moves. One example of such an option trading strategy is the Long Straddle which we mentioned above. This is because a typical delta neutral position is still Gamma positive, which increases position delta in the direction of the move, allowing the position to profit in either direction.

2. Delta Neutral Hedging — To Protect Position

Delta Neutral Hedging is an options trading technique used to protect a position from short term price swings. This is particularly useful for long term stocks or LEAPs option buy and hold strategy. The advantage of using delta neutral hedging is that it not only protects your position from small price changes during times of uncertainty such as near resistance or support levels, but it also enables your position to continue to profit from that point onwards if the stock rises or falls strongly.

Example of Delta Neutral Hedging For Stocks -

John owned and held 1000 shares of Microsoft for $27 per share on 14 March 2007. On 14 May, when Microsoft was trading at $31, John determined that a resistance level has been reached and wanted to perform a delta neutral hedge against a short term price change while being able to profit should MSFT rally or ditch strongly from this point. John bought 20 contracts of July31put to execute the delta neutral hedge.

1000 (delta of 1000 shares) — 1000 (delta of 20 contracts of at the money put options) = 0 delta

If MSFT rallies strongly from this point onwards, the put options simply expire worthless while the stocks continue to gain in value, allowing the position to continue profiting after the cost of the put options has been offset by the rise in the stock price.

If MSFT ditches from this point onwards, the put options will eventually gain in price faster than the stocks as 20 contracts represents 2000 stocks of MSFT, allowing the position to profit as long as MSFT continues to fall.

A delta neutral hedging for stocks actually creates a Synthetic Straddle options trading position.

Example of Delta Neutral Hedging For Options -

John owned and held 10 contracts of Microsoft’s March 2008 LEAPs call option at the strike price of $20 on 14 March 2007 when MSFT was trading at $27. On 14 May, when Microsoft was trading at $31, John determined that a resistance level has been reached and wanted to perform a delta neutral hedge against a short term price change while being able to profit should MSFT rally or ditch strongly from this point. Assuming the LEAPs call options has a delta value of 0.8, John bought 16 contracts of July31put to execute the delta neutral hedge.

800 (delta value of LEAPs options) — 800 (delta value of 16 contracts of at the money put options) = 0 delta

If MSFT rallies strongly from this point onwards, the put options simply expire worthless while the LEAPs options continue to gain in value, allowing the position to continue profiting after the cost of the put options has been offset by the rise in the LEAPs options.

If MSFT ditches from this point onwards, the 16 put options will eventually gain in price faster than the 10 LEAPs call options, allowing the position to profit as long as MSFT continues to fall.

Delta Neutral Hedging effectively Locks In the profits on your long term position right at the point the delta neutral hedge is put in place while allows you to continue holding your favorite stock or LEAPs. Without delta neutral hedging, the only way you can seal in profits is through selling the position. Options positions attain delta neutral through hedging based on a hedge ratio of -1.

Delta Neutral Hedging — Step By Step

Delta Neutral Hedging. Step 1

- Determine the total delta value of your current position.

If you are holding 100 shares, then you are long 100 deltas. If you are holding options, then you need to determine the total delta of your options by multiplying the delta value of each option by the number of options.

Delta Neutral Hedging. Step 2