Delta Neutrality and Associated Strategies
Jun 21, 2018
By: Sage Anderson
At my favorite burger place in China (a place called MASH in Shenzhen) the chef concocted something he calls "delta sauce," which he slathers on the buns.
Whenever I order a burger there, his famous sauce always reminds me of my day job - trading options. I've even borrowed his "delta sauce" phrase when referring to positions in my portfolio.
If I deploy a trade with a delta lean, I think about it as "with sauce," whereas delta-neutral trades get categorized as "without sauce” (i.e. plain vanilla). The vast majority are plain vanilla, by the way.
I mention it because today's blog post focuses specifically on delta-neutral trading, and I couldn't help but give a shout out to Chef Dennis at MASH and his amazing "delta sauce" in today's post.
An important thing to remember when trading options is that there's a "delta" component to every trade. That means a given position typically performs better if the underlying moves in one direction, as opposed to the other.
In that sense, the term “delta neutral” refers to the minimization of directional exposure. And trades that are hedged delta-neutral are also believed to be more of a "pure play" on volatility.
The delta neutral philosophy has been covered extensively on the tastytrade network, including a review of the “hard numbers” and some samples to help illustrate the P/L ramifications of trading delta neutral. If you haven’t yet reviewed that material, we certainly recommend doing so when your schedule allows.
If you are up-to-date on these tactics, but are seeking to add to your knowledge-base, we wanted to highlight two new tastytrade segments that feature new research related to the topic.
The first episode to check out is from the Market Measures series, and focuses on some unique considerations relating to the delta-neutral philosophy for retail traders - particularly rebalancing and commissions.
One of the biggest components when trading neutral are the adjustments necessary to keep directional exposure minimized on an ongoing basis. For example, let’s say you sell some calls and decide to balance directional exposure by purchasing stock against them (according to the “hedge ratio”). Now imagine that the underlying moves significantly lower.
At this point, a delta-neutral approach would indicate that stock should be purchased (after the down move) to once again balance the overall exposure of the position. This is an example of rebalancing the position, and interventions such as this may be required on a regular basis, depending on the volatility of the underlying.
One potential negative to these portfolio adjustments are the added costs stemming from commissions paid when trading stock. For large institutions, commision costs are negligible, but for retail traders, these fees can add up.
On the aforementioned episode of Market Measures, the hosts walk viewers through several exhibits which can help traders better understand how delta rebalancing can affect the potential P/L of a position - specifically by comparing frequent rebalancing versus less frequent rebalancing. We think the information presented on Market Measures is well worth a few moments of your time.
The second new episode we wanted to highlight is from the Options Jive series, and once again the focus is neutrality. However, in this case, the show compares two trading strategies that are “naturally” delta neutral - meaning the deployment of the position involves multiple legs, which effectively cancel out directional exposure.
The two strategies examined on Options Jive are a strangle and an iron condor. As you can see in the slide below, those two positions offer different strengths and weaknesses, depending on the risk profile one desires for a given idea:
The findings depicted above were the product of tastytrade research and you can find out more about the parameters of that analysis by tuning into the full episode.
Although iron condors and strangles both start out “delta neutral” at deployment, ongoing movement in the underlying stock alters the directional exposure of the position. That means a delta-neutral trader would need to make ongoing adjustments to the hedge - a reality that dovetails with our earlier point about commissions and adjustment frequency.
From a position management perspective, we think that these two episodes provide important context for traders, and may help you optimize your tactics going forward - so you can maximize reward, and minimize risk.
If you have any questions or feedback about delta neutral trading or any other trading-related topic, we hope you’ll leave us a message in the space below, or reach out directly at email@example.com.
Thanks for reading!
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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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