In options trading, the "Greeks" provide valuable insight into the risk profile of a particular option or position.
Theta tells us how much we are collecting (or paying) every day, vega tells us how much we can make or lose for a given move in volatility, and delta helps us understand how much an option's value will change as the price of the underlying fluctuates.
Delta is a somewhat unique "Greek," because the term may also be used to describe the directional exposure of a position.
For example, if a trader buys a naked long call, this position may be called "long delta" because it performs well if the underlying goes up. This is also a defined risk trade, from the perspective that the maximum amount the trader can lose is the total premium paid for the call.
The term "delta neutral" refers to a strategic trading approach that attempts to neutralize directional exposure, using the underlying security of the option.
This approach is underpinned by the belief that by hedging directional risk, a trader can isolate the volatility risk (mean reversion) that he/she is trying to capture.
Stated in more simple terms, trading delta neutral (when applied appropriately and consistently) can help traders reduce exposure in the event a position moves against them. On the flip side, this risk mitigation doesn't come without a cost - delta neutral trading can also take a bite out of potential profits.
In an effort to provide further context on delta neutral trading, consider the following hypothetical example.
Imagine that two different traders have been following stock XYZ for several years, and each noticed that XYZ's products experienced a spike in demand over recent months. XYZ is currently trading $10/share, and the company is set to report earnings in two weeks.
Intending to profit on a quick rise in the stock price after a good earnings report, both traders decide to purchase 100 contracts of the $11 strike front-month calls that expire in three weeks. They each pay $0.30 for the $11 strike calls, which equates to an outlay of $3,000.
Now consider one twist to the situation - while Trader A decides to sit tight with the naked calls, Trader B decides to hedge the position delta neutral. This means that Trader B will use the underlying stock to “flatten” the long delta exposure of the calls, as detailed below:
Trader A: Trader A purchases 100 of the $11 strike calls for $0.30 with the stock trading $10. Trader A does no stock against the long calls.
Trader B: Trader B purchases 100 of the $11 strike calls for $0.30 with the stock trading $10. The $11 strike calls have an associated delta of .30, and Trader B decides to hedge the position "delta neutral." This means Trader B sells 3,000 shares of stock XYZ short against his call position (# of contracts x option delta x option multiplier, or 100 x .30 x 100 = 3,000 shares).
Now let's look at some hypothetical situations for the day of earnings, and see how each of the respective traders (A and B) perform:
Scenario #1: Company XYZ reports fantastic earnings and the stock opens trading $12 after earnings are released.
Trader A: Trader A paid $0.30 for 100 calls that are now worth a $1.00. Trader A makes a profit of $7,000 on the trade ($0.70 x 100 x 100).
Trader B: Trader B also paid $0.30 for 100 calls that are now worth $1.00. However, Trader B additionally sold 3,000 shares of stock XYZ short for $10.00/share. That means Trader B has made $7,000 on his call position, but lost $2.00/share on the short shares ($2.00 x 3,000 = $6,000). Trader B, therefore, makes a profit of $1,000 on the trade ($7,000 - $6,000) with the stock trading $12.
Scenario #2: Company XYZ report fantastic earnings, but simultaneously announces accounting irregularities at the firm that are currently being investigated by the SEC. Stock XYZ opens at $8.00/share after earnings are released.
Trader A: Trader A paid $0.30 for 100 calls that are now worth at most a nickel, but likely will expire worthless. Trader A will likely lose his/her entire $3,000 investment in the call premium.
Trader B: Trader B also paid $0.30 for 100 calls that are now worth at most a nickel, but likely will expire worthless. Trader B will likely lose his/her entire $3,000 investment in the call premium. However, Trader B also sold 3,000 shares of stock XYZ short for $10.00/share. That means Trader B has made a profit of $2.00/share on the short shares ($2.00 x 3,000 = $6,000). Trader B therefore makes a profit of $3,000 on the trade ($6,000 - $3,000 = $3,000).
The above example should help illustrate how a delta-neutral trading approach can affect the range of expected P/L outcomes for a given position.
While the scenarios presented above represent extreme cases, traders can model any position for hypothetical moves in an underlying to gain a better understanding of their exposure. Likewise, traders can use this framework to ensure they have deployed a position that matches their outlook, expectations, and risk profile.
Any position, no matter how complex, is simply the sum of its parts. By breaking down the P/L of each component of a trade, traders can best understand how different moves in an underlying will affect the overall position, and more importantly, the bottom line.
We encourage you to model positions you are considering in the future to gain a better understanding of how they will perform under a variety of hypothetical circumstances. This type of activity can help unlock valuable information that traders can apply to future situations they encounter.
We are also planning some future posts covering additional aspects of delta-neutral trading, such as gamma scalping, which involves making adjustments on your stock hedge when the underlying moves.
In the meantime, if you have any questions about delta neutral trading, we hope you'll reach out at firstname.lastname@example.org at your convenience.
We look forward to hearing from you!
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.