Delta Hedging Options: When & How to Take Action
Oct 7, 2016
Many option sellers are unconcerned with market direction. They simply want to “sell the fat” or premium baked into an option contract. Oftentimes, traders initiate a neutral trade without opinion. Neutral trades have no positive delta or negative delta, they are delta neutral. Unfortunately, delta neutral trades rarely remain neutral and may require some tinkering to maintain neutrality.
At the time of this writing, the S&P 500 ETF, SPY, was trading around $214. To initiate a delta neutral strangle that expires in October, one might look to sell the 208 put and 221 call for a credit of $1.48. The put option has a delta of -0.22. Selling puts generates long delta. The call has a delta of 0.22. Selling calls creates short delta. Combining deltas from both option contracts cancels out one another. In other words, the trade is delta neutral.
The example above is a snapshot picture of what a delta neutral trade looks like when initiated. However, by the time I’m done writing this piece, chances are that position will no longer be delta neutral.
If SPY begins moving closer toward the 208 put in the above example, that strangle begins taking on a bullish directional bias. Stated differently, the trade is no longer delta neutral. An option’s delta fluctuates with changes in its underlying stock, changing a neutral trade into a directional one. When trades become directional, we can make adjustments bringing them back toward neutrality.
One of the most common delta adjustments we can make is using stock. Each share of stock equals one delta. That never changes. We call that “static delta.” Therefore, we can either buy or sell short stock to neutralize our deltas. To do this, we simply buy (sell) the same number of shares as deltas we wish to adjust. For example, if we want to add one delta to the example above, we would buy one share of SPY. If we want to add ten deltas, we buy ten shares. The same holds true for increasing short deltas; we simply sell short shares.
Deltas can be adjusted in ways other than using stock. Options can be rolled on the untested side to a different strike price. In our example, if SPY falls toward 208, our long deltas will increase. To counter this, we could buy back our 221 call then sell, or “roll down,” to a call with a lower strike price, which would have the effect of increasing our short deltas.
Another way we can adjust deltas are by adding more contracts to a trade. If SPY moves down all the way to 208, its delta will become .50. An at-the-money (ATM) option always has a delta of 50. To neutralize this, we might look to sell an additional 221 call. That will increase our short delta and help balance our trade.
Finally, another alternative for adjusting deltas might be to create an entirely new position in a correlated product. Often times, when we create occurrences we look to do so in uncorrelated products. However, when we are seeking to adjust deltas, we may turn to correlated products. For instance, if we initiate a neutral trade in Apple (AAPL) and the stock moves up, thus increasing our short delta, we may look to sell puts in the Nasdaq 100 (QQQ).
Neutral trades are balanced trades. They are strategically geared toward collecting premium and become profitable as that premium erodes over time. These types of trades do not care about direction initially. Maintaining that neutrality often requires making position adjustments. Fortunately, there are multiple ways to go about making those adjustments.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.