The typical options investor is trying to leverage options trading to speculate on directional moves in the prices of underlying assets. However, there are more sophisticated traders who would like to profit from other characteristics of options.
To pursue these trading strategies, investors need to minimize the effect of price changes and create portfolios that profit from and are more sensitive to these other factors. Delta neutral approaches allow investors to create these portfolios.
What Is Delta?
Delta is one of the Option Greeks and measures how much an option will change in price, given a $1 change in the price of the underlying asset. By definition, the delta of the underlying asset is always 1.
What Does Delta Neutral Mean?
Delta neutral means that a position’s value will not change when there are small market price changes. By holding a combination of assets and options, or combinations of various call and put options, a trader can create a portfolio with an overall delta of zero (in actual practice, very close to zero).
Traders use delta neutral strategies to minimize the effect of price changes while aiming to profit from shifts in implied volatility, the time decay of options, or simply to hedge against price movements.
How Does Delta Neutral Function?
A portfolio’s overall delta is determined by the sum of the deltas of its individual positions. Let’s take a closer look at the delta in options and securities.
Basic Mechanics
A trader holding shares (“going long”) benefits one-for-one from increases in the stock price. The delta for long shares is 1.
Investors short a stock will experience losses one-for-one as the share price rises, but they will benefit in the same amount when it falls. The delta for short shares is -1.
In the options trading world, a long call option has a delta of 0 to 1, while a long put option has a delta of –1 to 0.
Deep in the money long call options are most likely to feature a delta near 1. Deep out of the money long call options will have a delta near 0. At the money long call options typically have a delta near 0.5.
Deep in the money long put options typically have deltas near -1. Deep out of the money long puts have deltas near 0 and at the money long puts have deltas near -0.5.
Deltas values are for each individual security held and need to be adjusted based on your actual holdings. If you own 200 shares of stock, the delta for this position is 200. If you own an at the money call options contract, the delta for this position would be 100 x 0.5 or 50 due to options representing 100 shares of the underlying asset.
If you are writing (“going short”) options, the deltas values are reversed. If you write a call option with a delta of 0.75, then the delta for the position would be -75. Similarly, the delta for shares sold short is -1 per share.
The investor must also be aware that any delta neutral portfolio will only be neutral over a range of asset prices. An option’s delta is always in flux as it moves in and out of the money. A portfolio must be constantly adjusted to maintain delta neutrality – many delta neutral trades must be executed.
An Example of Delta-Neutral in Use
A trader might employ a delta neutral trading strategy when they are long shares of stock but are concerned about a near-term pullback in its price. Assume the trader owns 100 shares of XYZ stock at $100 per share. A long stock position has a delta of 1. Multiplied by 100 shares, the position has a total delta of 100.
The goal of a delta neutral strategy is to use a combination of calls and puts to bring the portfolio’s net delta to 0. One possibility is to purchase at the money put options that have a delta of -0.5. Two of these put option contracts have a total delta of -100 (-0.5 multiplied by 200 options). Recall that an options contract represents 100 shares of stock.
Here, the $100 strike is the delta neutral strike. As the underlying price moves away from $100, the delta of the portfolio will move.
Combining the deltas of 100 shares together with 2 long put option contracts with a -0.5 delta yields a delta neutral portfolio.
Stock position delta = 100 shares x delta of 1 = 100
Long put position delta = 2 contracts x 100 shares/option x delta of -0.5 = -100
Portfolio delta = stock position delta + long put position delta
Portfolio delta = 100 + -100 = 0 or delta neutral
The net position is protected from losses by being long put options while still having exposure to upside from the long stock position. Of course, there is a cost to purchasing put options.
A diagram might help illustrate what is delta neutral.
Profit & Loss Diagram Using the Above Example (Not Including the Put Option Cost)
Profiting From Delta-Neutral Trading
It is possible to profit from changes other than price movements in the underlying stock. For example, an options trader can use delta neutral strategies to benefit from declining or rising volatility. Vega is the Options Greek that tells a trader how much the price of an option will move in response to changes in volatility.
Delta neutral strategies can also be used to profit from time decay or – as in the earlier example – to hedge an existing long stock position. Writing options allows you to benefit from the effect of time decay, but there is a risk of assignment. If the underlying stock price moves significantly, the contracts could be assigned to you.
Shorting Vega
Shorting vega is a more advanced options trading strategy. A delta neutral approach can be used to benefit from collapsing volatility.
You might look to short volatility after a period of extreme movements in the market or a single stock. The key is to short vega when implied volatility is still high and you expect it to come back down.
When implied volatility is high, you pay a significant premium to be long options. You can take advantage of expensive options when implied volatility is high by selling options while still being delta neutral. The risk is that implied volatility levels continue to jump, which can lead to losses on a short vega play.
Waiting for Collapse in Volatility
A short vega position relies on the implied volatility on the underlying security to drop in order to turn a profit. It might take patience for implied volatility to drop to historical norms. To remain delta neutral, other positions might have to be put on to mitigate the risk of a change in the underlying stock price.
Pros and Cons of Delta Neutral Positions
Some of the pros of crafting a delta neutral portfolio have been highlighted, but there are downsides as well. Having to closely monitor your portfolio can be a burden, while trading costs mount as you constantly layer on or reduce hedges to keep near delta neutral.
| Pros | Cons |
|---|---|
| Profit from variables other than the price movement of the underlying asset | Requires frequent trades, which could be costly, to maintain a delta near 0 |
| Traders hold stock for the long run while protecting against near-term declines | Deltas are constantly changing resulting in being over- or under-hedged |
Delta Neutral Straddle
A delta neutral straddle uses a combination of puts and calls to keep the position’s delta near zero while having exposure to volatility changes.
For example, if XYZ stock trades at $100, and it’s at the money call has a delta of 0.5 and it’s at the money put has a delta of -0.5, you can buy the put and call with the goal of selling them after implied volatility jumps. With this delta neutral long straddle strategy, your delta is effectively 0 but you are long volatility.
A delta neutral short straddle is an options trade that seeks to profit from minimal changes in the underlying stock price and a large drop in implied volatility. So, the reverse of a long straddle can be used when you believe implied volatility will drop.
Other options trading strategies used to profit from changes in volatility and time decay are calendar spreads, diagonal spreads, iron butterflies, iron condors, among others.
The Takeaway
Building and maintaining a delta neutral portfolio can be a challenging task, but profiting from time decay and changes in volatility can make it worthwhile and profitable.
Delta neutral trading can also hedge your portfolio from short-term declines while continuing to hold stock for the long-term.
Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.
FAQ
How do you make money with a delta neutral strategy?
You profit from a delta neutral option strategy when there are changes in a stock’s variables other than its share price. Changes in implied volatility create opportunities to go long or short volatility while being agnostic to the stock price’s change. You can also benefit from time decay by selling options while being delta neutral.
What is a delta neutral strike?
A delta neutral strike marks the price at which a portfolio is precisely delta neutral. In practice, it is more of a theoretical price rather than an exact level. When the underlying asset price moves up or down from the delta neutral strike, its delta will stray from zero; it will take additional hedging trades to get back to delta neutral.
How can you calculate the value of your delta neutral position?
To calculate your position’s delta, simply multiply each security’s delta by your position size. For example, one call option contract with a delta of 0.75 has a delta of 75 (0.75 x 100 options per contract). While being long 100 shares of stock with a delta of 1 has a delta of 100 (1 x 100 shares).
You combine the deltas of all positions in your portfolio to determine your overall delta. At that point, you can trade options to make your portfolio delta neutral.
Photo credit: iStock/Delmaine Donson
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