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Delta Hedging: When and How to Take Action

Best Practices

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Our favorite premium selling strategies are Delta Neutral ones like short Straddles and Strangles. A Delta Neutral strategy has no directional bias at order entry when the Delta of the position will be close to or at zero. A quick look at the P/L graph of a 1 Standard Deviation (SD) Strangle makes it clear that as the underlyingchanges in price the trade the Delta changes and the trade can become directionally biased. When and how do we make adjustments to such positions?

When we are short a Strangle we will first take action either when one of our break-evens is breached or when one of our short strikes is tested. One way of doing so is by using Static Delta. This means establishing a short or long position in the underlying to counter the current Delta of the position resulting in a new Delta Neutral position.

An alternative to the use of Static Delta is to roll the untested side of our short Strangle closer to the current price of the underlying. This brings in additional premium in addition to bringing the position back closer to one that is Delta Neutral. Additionally, we can add extra positions to our portfolio in the same underlying and/or in correlated positions such as a position in QQQ options to offset a position in AAPL options. Tom remarked that, “What makes us most nervous is when we start out with short Deltas [which protects us against large down moves and explosions in Implied Volatility] and we lose our short Deltas and then something big happens in the market.”

For more information on Delta and Hedging see:

Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding on how and when to react when a short Delta Neutral strategy is no longer Delta Neutral.

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