What if there was an investment strategy that was inherently protected from risk, and could profit no matter what direction a stock’s price went? Seems too good to be true, right?
In the regular market, sure. That’s too tall of an order. But in the quantum realm of options, all sorts of interesting possibilities can come to life.
A delta neutral strategy highlights some of the exotic ways options can capture profit while also mitigating risk. We’re going to give you an in-depth guide of this strategy so that you can understand it well enough to use it and take advantage of its benefits.
What you’ll learn
First: Understanding Delta Value
Delta is one of the “Greeks” in options, which are different variables used to assess risk in the options market. Delta is a measure of how much the premium (which is considered the purchase price) of an option will move (in theory) based on a $1.00 move in the underlying security. Deltas can range from -1.00 to 1.00.
For example, if a Paypal (PYPL) call has a delta of 0.35, this means that, in theory, if the underlying security (PYPL) moves up by $1.00, then the PYPL call’s premium will go up by $0.35. If the delta was negative, the premium would go down as the underlying security’s price increases.
There are other Greeks too, such as gamma, theta, and vega. But we won’t be talking about those here, for now, we’ll just focus on delta.
What’s a Delta Neutral Strategy in Options Trading?
A delta neutral strategy is a strategy that seeks to create a well-balanced group of investments that, overall, are affected very little by small movements in the prices of the underlying securities.
The strategy’s set up is how it protects itself from movements in the underlying. It is naturally hedged because the positions open in a delta neutral strategy counteract, or neutralize each other, which is what brings the overall delta close to, or equal to zero.
A position with an overall delta of zero means that, in theory, it will not be affected by the underlying security’s price movements. So to set up a delta neutral options strategy, you’ll need to know how to calculate the overall delta. This is very easy – we’ll show you how
To calculate delta-neutral, first, find the deltas of the different positions you have, then add the deltas from the long investments, and subtract the deltas from the short investments. The total is your overall delta. The closer the total is to zero, the more neutral, and thus more balanced the strategy will be.
Here’s an example: say you wanted to set up a straddle, a basic options strategy. A straddle is where you have one call and one put associated with the same underlying security that have the same strike price and expiration date.
As of October 19, a Netflix (NFLX) call option with a $265 strike price that expires on Nov 18 has a delta of 0.58. A put option with the same variables has a delta of -0.42. This means that the overall delta would equal 0.16. So for every $1 move in the underlying price of Netflix, in theory, your position will move $0.16.
The delta in this example is not zero, and therefore not completely neutral, but it is close. You can always look for another option with a different delta – options with different strike prices will have different deltas.
Delta Neutral Strategy #1: Covered Calls
A covered call is a common options strategy where an investor writes, or sells a call, while also owning corresponding shares of the underlying security. Let’s see how the play is set up using Shopify (SHOP) as an example.
To set up the play, you’d long 100 shares of SHOP for every one call contract you short. Options represent 100 shares of the underlying security they’re tied to, which is why this play is balanced – because for every 100 shares you own, it’s balanced with one short call.
For a delta neutral strategy, it can’t just be any call though. The call needs to have a delta that neutralizes the delta of the shares you long. Let’s look at how to do that.
Creating a Neutral Delta
Now, because delta represents a $1 move in the underlying security, if we long 100 shares of SHOP, we’d have an initial delta of 100. To neutralize the delta, we’d need to find a SHOP call option with a delta as close to 1.00 (100) as possible to bring the overall delta as close to zero as possible.
Let’s imagine SHOP is currently trading at $28.00.
We know with calls that the lower the strike price is, the deeper in the money the contract is. And the deeper in the money the call, the higher the delta is expected to be.
Now let’s dive into a specific example.
10/28 expiration SHOP short calls:
- $27 strike price, delta = 0.66, or -66.
- $22 strike price, delta = 0.93, or -93.
- $17 strike price, delta = 0.99, or -99.
So if we hedge our long SHOP position with the third call in the list above, our overall delta would be -1, or 0.01. Remember that the deltas for these calls are negative because we are shorting them.
This is an example of how options can be used to hedge positions, and help neutralize delta. It’s not so complicated, right?
You don’t always need to short one call for every 100 shares you long, but it’s a good idea if you want to take on less risk. The more risky scenario would be to use more than one call to create a neutral delta.
A SHOP call with the same expiration date and a $29 strike price has a delta of 0.47, so two of these would have a total delta of 0.94, or -94. So with two calls you could have an overall delta of -6.
This is a riskier scenario because you are using margin to short your call, which exposes both you and your brokerage to much more risk/ potential loss. Brokers don’t like this risk – which is why each trader will need to be granted the appropriate level of options trading in order to prove that their trading experience and income level allows them to take on such risk.
Delta Neutral Strategy #2: Long Calls and Puts
With the last strategy we neutralized delta by shorting one or more calls to balance long shares. With long options, you can balance the delta of a call with a put, or visa versa.
Long calls have a positive delta, and long puts have a negative delta. So the first thing you’ll want to do is simply choose a call or a put to start with, and then find a call or a put that can neutralize the delta.
Now this strategy does have an inherent downside due to using long options, and that downside is time decay. Time decay eats away at the value of long options as time passes. This is an important factor to consider when thinking of employing long options in your investment strategy.
Creating a Neutral Delta with Long Calls and Puts
Here is a list of SHOP calls with various strike prices. After we choose a strike price that suits us, we can find its matching ‘put pair’.
10/28 SHOP long calls:
- $33 strike price, delta = 0.23, or 23.
- $28 strike price, delta = 0.56, or 56
- $23 strike price, delta = 0.86, or 86.
Now let’s choose one and create a neutral delta. We’ll choose $28 since it is right at the money. To demonstrate how delta can be different depending on the type of option, we’ll list SHOP puts with the same strike prices and compare the deltas.
10/28 SHOP long puts:
- $33 strike price, delta = -0.76, or -76.
- $28 strike price, delta = -0.44, or -44.
- $23 strike price, delta = -0.13, or 13.
In comparing the deltas of the calls and puts, it becomes obvious that we can’t just choose the same strike price for the other option, we need to shop around or a delta that fits. In this case, a SHOP put with a $30 strike price has a delta of -0.58, or -58. This is the closest fitting delta to the call that we want to long.
So, your overall delta would be -0.02, or -2, which is as close as you can get to a neutral delta considering the call we chose. It’s not a bad idea to keep checking out other strike prices and assess what your goal is with the position to find an option and delta that fits within that goal.
Delta Neutral Strategy #3: Credit or Debit Spreads
The previous two delta neutral strategies we’ve discussed have involved ‘regular’ shares of stock. But it’s also possible to create a delta neutral strategy built strictly from option contracts. The key to understanding how this works is to first understand credit and debit spreads.
There are many different types of spreads, all of which involve the simultaneous purchasing of two or more option contracts. These options can have different strike prices and expiration dates, which both affect the option’s delta.
Firstly, what makes a spread a debit or credit? Going back to accounting 101, a credit means money coming in, and a debit means money going out. So when you long an option, money goes out – so that’s a debit. If you sell an option, money comes in, resulting in a credit.
If for example you sold a put that has a $5.00 premium, and bought a put that has a $3.00 premium, you’d have a net credit of $2.00. This is a basic example of a credit put spread.
Setting Up the Strategy
Now let’s get into a more specific example, and how to set it up so that the position is delta neutral. We’ll use Twitter (TWTR) in this example, and we’ll set up a call debit spread, which is also known as a vertical spread. Check out this image below for a visual of a vertical spread.
With spreads, either the strike prices, or the expiration dates are held constant, and the other variable is different. When graphed, you can see what that actually looks like.
We know from the name of the strategy that we will need calls, in this case two. One long and one short. And since it’s a debit spread, we’ll make sure that the call we long has a higher premium than the one we short so that the position results in a net debit. As is the typical nature of vertical spreads, the options used will have different strike prices but the same expiration date.
Creating a Neutral Delta with Spreads
Now we need to find two calls with deltas that neutralize. How does that work with credit and debit spreads? Remember – we’d need to purchase two different options contracts with the same underlying security.
Here are two TWTR calls with slightly different strike prices, but with the same expiration dates:
- Long call: Nov 25 exp., $50 strike price, 0.69 delta.
- Short call: Nov 25 exp., $49 strike price, (-)0.73 delta.
In this example, the overall delta would be -0.04, which is very close to zero, and therefore quite neutral.
Benefits of Delta-Neutral Positions
Options contracts open doors to new opportunities that you won’t find in the regular markets. Delta neutral positions are a great example of an option strategy that has some unique benefits.
The strategy proves to be highly beneficial for investors that are looking to shed the effects of time decay (aka theta decay), profit in volatile markets, and mitigate risk. While there are certainly risks and dangers (which we’ll get into later), there are clear advantages as well.
Let’s explore the specifics of these benefits.
You Can Profit from Time Decay
When you long calls and or puts, they are subject to the effects of time decay. The closer the option gets to expiration, the less time the investor is able to exercise their right to buy or sell the underlying security, thus making the option less valuable. This is the effect of time decay.
However, when you short, or write/ sell a call or put, the effect of time decay is the opposite. Writing options is necessary in creating a delta neutral strategy, so they’ll inherently be built into your set of positions. This means they’ll allow you to reap the benefit of time decay, which is often the bane of options traders.
You can see in the image below how time decay would normally affect the value of an option. Note that as the expiration date gets closer, the effects of time decay are magnified. This is a huge risk long options traders take on, but something that a delta neutral strategy doesn’t have to worry about.
Note that in the image above the effect of time decay is gradual. And over time, especially after the 30-day mark, the value starts slipping, exponentially decreasing until the contract expires worthless. A delta neutral strategy steers clear of this slippery slope.
Profit from Volatility
Large swings in price can be beneficial for some investors. In fact, TTAs strategy capitalizes on swings in price to capture profit in the short-midterm. But volatility can create difficult terrain to navigate through and come out of successfully. You can get around this by following options signals, which – if done correctly – notify traders of profitable trades by a team of professional traders.
Delta neutral strategies also avoid, or rather, shield from the effects of volatility. Because of their setup, it doesn’t matter if the price goes up or down. This is because in order for the strategy to have a delta that’s neutral overall, you need negative deltas and positive deltas.
Protection: Use Delta Neutral as a Hedge
When you create a delta neutral position, you don’t expose yourself to the risk of having an investment that’s heavily weighted in one direction. Because you have a position that can profit in both directions, the overall position is hedged, or protected against downside risk.
In our examples with covered calls and cash-secured puts, the shares you either long or short are hedged by the either call(s) you short or the put(s) you long. You can also hedge options with options. We saw this with spreads.
Across the board, rookies and veterans use options to hedge positions. This is the essence of hedge funds, constantly hedging the risk of investments, striving to have a balanced portfolio. Managers of these funds use options to create this balance all the time.
While delta neutral options strategies aren’t the ideal techniques for beginner options traders, they do create a myriad of opportunities and benefits for investors. Namely, investors that use a delta neutral strategy hedges risk via the setup of the position, mitigates, if not eliminates the effect of time decay, and can help realize profit in volatile markets.
A neutral delta just means that the overall delta of the position is zero. This is calculated simply by adding together the deltas of the investments you long, and subtract the deltas you short. The net result is the total delta of the position.
Overall, delta neutral strategies are great for those that are interested in trading options, but maybe aren’t sure where to start, or maybe are worried about the risk you can take on with other strategies.
Delta Neutral in Options Trading: FAQs
Is a Straddle Delta Neutral?
Yes, both long straddles and short straddles are delta neutral. This means that straddles will always have a “near-zero” delta.
Is a Delta Neutral Strategy Profitable?
Yes, a delta neutral strategy is generally profitable. In fact, a delta neutral strategy can profit if the underlying price goes up or down.
What’s the Point of Being Delta Neutral?
The point of being delta neutral is to reduce risk, increase chances to profit, and shed the effects of time decay. In these ways, there are multiple benefits to being delta neutral – but the difficult aspect is actually achieving that neutrality.
Are Market Makers Always Delta Neutral?
Market makers are almost always delta neutral. This is because they’re incredibly liquid, and achieving delta neutral status is a bit easier for them than it is for standard retail traders.