(Please note: page references and some referenced charts are not applicable in this excerpt)

"Delta neutral" is a concept that is getting a lot of publicity lately. Our feature article looks at some of the pluses and minuses surrounding the strategy. Like anything else, this strategy takes work to make profits. Sentiment remains mixed, although it is leaning to the bearish side - page 5. There are really outrageous sentiment figures in some of the sectors and futures markets, and we make three conditional recommendations based on put-call ratios - page 6.

Implied volatility spiked higher when the market fell quickly on Wednesday. When it peaks, that is often a short-term buy signal for the market. There are plenty of interesting volatility trading situations, and we have positions in a number of them. Two new positions — one in futures and one in stocks — are listed on page 7.

Speculation is heavy in a number of stocks. This creates expensive options, and sometimes the only way to trade these is with a bull spread. To that effect, we are recommending bull spreads in both Fleet Financial and American Power Conversion (page 8), where options are expensive and volume is heavy.

DELTA NEUTRAL HOW GOOD IS IT?

At the Futures South Conference last month, there was a lot of talk about delta neutral strategies. We're going to take a look at what these strategies are, and why they're not as profitable and easy to operate as some advisors would have you believe. I have mentioned in the past that I have some trepidation that too many traders are embarking on delta neutral strategies without understanding that like any other strategy they involve work to operate profitably.

The attraction of a delta neutral strategy is that, in theory, one does not have to predict the price movement of the underlying security. Rather, he sets up a delta neutral strategy (which should have some other "edge" in terms of volatility, perhaps) and can theoretically make money because of his "edge", regardless of what happens to prices. That's the theory. In practice, it's a lot harder than that. Let's look at some actual delta neutral strategies.

All delta neutral strategies require at least two different options to be in the position, for the way we determine delta neutral is to divide the deltas of the two options in question.

Example: Suppose IBM is at 157, and we want to establish a delta neutral call ratio spread using the Feb 155 and Feb 165 calls. The delta of the Feb 155 call is 0.60 and of the Feb 165 call is 0.25. To determine the delta neutral ratio, merely divide the two deltas: 0.60/0.25 = 2.4, or 12 to 5. So buying 5 and selling 12 would be a delta neutral spread.

The above example is that of a neutral position involving naked options. However, one can also establish a delta neutral position with only long options.

Example: Again using IBM, suppose that you think the stock will be volatile, so you want to own some options. The April 160 call has a delta of 0.50 and the April 150 put has a delta of 0.30. The neutral ratio between these is 0.50/0.30 = 1.67, or 5-to-3. Thus if we were to buy 5 of the puts and buy 3 of the calls, we would have a neutral position.

Most of the hedged positions that we recommend in The Option Strategist, for purposes of volatility trading or for trading the volatility skew, are roughly delta neutral to begin with. And therein lies the rub: any delta neutral position is only delta neutral to begin with. Delta changes as soon as the underlying price changes, or when time changes, or when volatility changes. Thus, it is a virtual certainty that the deltas will soon change, and it is therefore quite likely that your delta neutral position won't be neutral any more.

Once your formerly delta neutral position takes on a delta long (bullish) appearance or a delta short (bearish) appearance, you are then once again in the business of predicting prices, which you supposedly didn't want to do in the first place. You have two choices at that point: first you can re-neutralize your position by buying or selling a few options, but the commission and adjustment costs can become quite large if you do this repeatedly (in fact, the only traders who keep their positions extremely neutral are exchange members and market makers who are trading without commission costs). Second, you can handle the position by trying to predict prices.

Even if you do adjust to delta neutral, you are in effect predicting prices to a certain extent, because your adjustment affects the total outcome of the position.

Example: Assume that you had established the IBM call ratio spread on the bottom of page 1, having bought 5 Feb 155 calls and sold 12 Feb 165 calls. Shortly thereafter, IBM makes a quick move to the upside and is trading at 172. You are now nervous because your position is quite delta short and you stand to lose a great deal of money if IBM were to continue rising rapidly.

Therefore you decide to buy something (it doesn't matter what for the purposes of this example either stock or some calls) to reduce your risk and re-establish a neutral position. While it's true that your adjusted position may be delta neutral once again, you have in effect said that you don't think IBM will fall in price (if you did think that, you wouldn't bother adjusting). So, in effect, even neutralizing the position involves a market prediction.

In general, the following graph shows how the delta would change in ten days, at various IBM stock prices. Note that even if IBM stays right where it is, the position starts to become delta long (the curve in the graph is above the axis), while if IBM begins to rally, the position can become quite delta short.

The same sort of thing happens even more dramatically in the case of the long straddle. Alex Jacobsen, who heads up The Option Institute (the CBOE's instructional arm), has a good way of describing this: he says that owning a straddle is not a neutral position at all; it's merely a position waiting to tell you in which direction you're going to be trading the market. That is, if the underlying rises in price, you are quickly delta long if you own a straddle, and therefore you trade it as if it's a long position. On the other hand, if the underlying declines in price shortly after you've purchased a straddle, you become delta short and are forced to trade the position as if you were short.

There is nothing wrong with this. In fact, it's often a good way to get into a position before a breakout. We recommend a lot of long straddles in this newsletter, and as you see if you pay attention to our follow-up action, we usually try to ride with the trend once one is established by a breakout. That's why we're still long the Swiss Franc puts in Position F122: once the currency broke out to the downside, we sold off the long calls and have held the puts with a trailing stop, building up very good profits as the trend continued.

These examples should have amply demonstrated that a "delta neutral" position quickly becomes price sensitive thereby negating the supposed "advantage" of the concept of not having to predict prices. So, you might ask, "Why bother with this delta neutral business when I just wind up having to predict prices anyway?" Good question. The answer lies in the fact that there are often times when you can have an advantageous position that doesn't require much attention for a while. Then, when it does, you may already have a profit or may be able to remove the position with only a small degree of risk.

 Let's take the call ratio spread as an example. The position normally has a profit graph of the shape as shown on the right. If you establish the position when the underlying futures contract, stock, or index is where the "X" is on the chart, then you can often sit back and watch the position develop without having to worry about price changes unless they get extreme. For example, if the underlying falls in price, you won't lose or make anything you have merely tied up your capital. If it rises relatively slowly, and takes some time before it reaches the higher striking price ("S" on the graph), then you could easily have a profit by that time. The curved line on the chart shows where profits might lie at that time. In that case, you could just take your profit and be done with the position. The third scenario quickly rising prices is the one that would cause problems for the ratio spreader, and he would have to play defense to limit his losses before they became quite large.

The point is that the ratio spreader can maintain a relaxed demeanor until the underlying crosses through the upper striking price ("S"). This, then, is the advantage to the delta neutral strategy it can buy a person time before decisions have to be made, and profits may accrue in the meantime.

Similar things can be said about the long straddle as well, although they occur in a reverse sort of way. If nothing happens when you own a long straddle, that's not good although we usually recommend staying with the position for a while before giving up on it. For example, you might initially say that you'll risk 50% of the initial purchase price of the straddle. It would take some time before time decay eroded the straddle by half its value, but if it did, you would take your loss and go on to the next position. While a 50% loss is substantial, ideally you would have some very large profits in a few situations to offset those losses caused by time decay. Of course, if the underlying makes a big move in either direction, then you might have to trade the position with the trend, but at least you would be doing so from a profitable manner, hopefully.

The key to our approach to the delta neutral strategy is not to just willy-nilly throw these delta neutral positions on all over the place, but to have a reason for establishing them. That reason would most likely be an aberration in volatility ("volatility trading"), perhaps coupled with a volatility skew that is in your favor a situation often found in futures options in particular.

New LEAPS options have been listed on Household Int'l (HI). The Jan 1998 LEAPS use the symbol WOH, and the Jan 1999 LEAPS use the symbol VOH.

The long advance in stock prices has gotten us to the point where many of the broad-based indices now need four base symbols to delineate all the options. The ones that were faxed to us this week include:

There are assuredly others. These are just the ones that the exchanges sent to us this week. Longer-term subscribers may recall that we, at one time, had a theory that when additional symbols were needed, it was a sign that the index had risen too far, too fast. While the theory was useful for awhile, it obviously is outmoded now as these indices just keep climbing to the sky.

Oscillator: the oscillator gave a sell signal on Thursday, January 22nd's close. Once again, it preceded a swift, but brief, move in the market as measured by OEX. The index dropped over 2% right away (a partial profit point), but then rallied and stopped us out when it closed back above 764.

Position E63: the Telefonos de Chile (CTC) long calls were stopped out when CTC closed below 25.

Position F122: lower the trailing, closing stop on the Swiss Franc Mar 75 puts to 72.00, basis March futures.

Position F120 & F124: the Orange Juice ratio writes. These March options all expire on Friday, Feb 7. See page 7 for May strategies.

Position F127: given the mixed nature of our indicators, we recommended a put ratio spread in S&P. It is discussed in more detail on page 5: buy 1 Mar 790 put, sell 1 Mar 770 put, and sell 1 Mar 745 put.

Position I108: the Value Line-S&P spread: Close the spread if it widens to 85.10, on a closing basis.Position I112: the OEX call ratio spread. Continue to hold with the plan to close it if OEX trades at 680.

Position S201: we sold 40% of our position in DSC Communications (DIGI) calls and raised the closing stop to 20½ on the balance.

Position S207: raise the stop on the Cellstar (CLST) calls to 19½, closing, and sell half your position.

Position S208: the stop for the Checkpoint Systems (CKP) long puts is 21-3/4.

Position PC11: the long Feb Live Hog puts were sold.

Position PC19: tighten the sell stop on the Corn calls to 268, closing, basis March Corn futures.

Position PC21: raise the closing stop on the $MEX long calls to 90.00, basis the index.

Position PC23: we rolled up the Coffee long calls again, from the Mar 120s to the May 140s.

Breakdown by general investment strategy:

Examples:
Equity & Index Option Symbols = stock symbol + month code + strike code

Month Code: For calls, Jan=A, Feb=B, ... , Dec=L; for puts, Jan=M, ... , Dec=X

Strike Code: A=5, B=10, C=15, ... , R=90, S=95, T=00 (or 100)

IBM July 90 put is IBM SR;

OEX August 550 call is OEX HJ

  The market's push to new highs has not been confirmed by uniformly lower readings on the put-call ratios, as one might expect. In fact, two of the four broad put-call ratios that we follow are giving sell signals now, while a third is very near a sell signal as well. Specifically, the equity-only ratio (above, left) has jumped higher. We have a sell signal when a local minimum (i.e., a bottom) has been formed on the chart. That appears to have occurred, although the overall downtrend from last August's peak is still in effect. Therefore, we have marked the current sell signal with a small "s". We would change it to a full-fledged sell if the downtrend is broken i.e., if the equity put-call ratio moving average climbed to 40 or higher.

On the chart, above right, the total put-call ratio has given a sell signal as well, and it has come from very low levels for that average. The S&P 500 put-call ratio (chart in insert) is beginning to edge higher and is very close to a sell signal as well. However, the OEX Index (above, right) ratio remains out of synch with the others it is still distorted by the heavy institutional put buying of last fall.

Overall, these indicators are at least slightly bearish. However, we have seen from the other small "s" sell signals on the equity-only chart that this powerful bull market tends to digest these quickly. Of course, the day will come when a full-fledged decline takes place, and this may well be it, but we want to see the equity put-call break its downtrend line before taking a fully bearish position. Also, our oscillator while overbought at +88 as of Tuesday night is not near a sell signal right now.

Thus, we feel the best strategy is either a backspread, such as position I111, or a put ratio spread. The put ratio spread recommended on last week's HOTLINE is also a viable strategy, although it requires a substantial margin requirement (as do any OEX or S&P strategies involving naked options). We will describe it briefly again, for those who did not call the HOTLINE:

Position F127: S&P Put Ratio Spread
Buy 1 S&P Mar 790 put,
Sell 1 S&P Mar 770 put,
Sell 1 S&P Mar 745 put,
1 point=$500; options expire 3/22/97
SPH: 782.55 Mar 790 put: 23.05
Mar 770 put: 14.40 Mar 745 put: 8.20

The maximum profit potential (about $10,000) is between 745 and 770 at March expiration, but there is risk of substantial loss if March S&Ps should fall below 725 before expiration. So, if having naked puts on the "market" makes you nervous, then don't establish this position. Allow $25,000 in margin for this position (which can be in T-Bills). Place a GTC STOP order to sell one March S&P at 724, but also call the HOTLINE if Mar S&Ps trade down to 740.

There are two sectors that are giving new signals, and the currencies remain on "buy alert". We are therefore going to make contingent recommendations in each of them. Be sure to adhere to the contingencies as these markets will need to reverse trend for these trades to be successful.

Position PC26: Contingent SF buy.
If June SF futures close above 72.70, then
Buy 1 SF Jun 73 call
1 point=$1250; options expire 6/6/97
SFM: 71.09 June 73 call: 1.18

This is a repeat of the same recommendation that we have been making for a couple of weeks. We continue to feel that the currencies (the Yen is attractive also) will have a good rally, but we want a little price confirmation first.

Position PC27: Contingent $SOX put buy
If the $SOX closes below 276, then
Buy 1 SOX Mar 275 put
$SOX: 275.14 Mar 275 put: 12-3/8

The Semiconductor Index ($SOX) put-call ratio has bottomed and risen sharply. The options are not expensive, by historical standards, so we are recommending an outright put purchase rather than a spread.

Position PC28: Contingent buy in Japan Index
If JPN closes above 187, then
Buy 2 JPN Apr 185 calls
$JPN: 183.69 Apr 185 call: 8

The buy signal is in place, according to the put-call ratio, but the Japan Index has been repelled several times just below the 187 level, so we want to see a close above there.

In other areas, the metals are giving mixed signals. Gold put buying is still the heaviest of the three sectors we watch (gold futures, silver futures, and the XAU Index). There are way too many call buyers in silver, and the $XAU ratio is modestly positive. Altogether, the metals are setting up for a buy, but not yet.

At-the-money Options: Current Data & Recent History

Just as we went to write this column (on Wednesday afternoon), the market collapsed heavily. That collapse inflated volatility quickly and extremely, and pushed the Volatility Index (symbol:$VIX; chart in insert) to new relative intraday highs. The chart in the insert only includes closing prices, but a peak in $VIX is usually a good buy point for the market (or is a good place to sell naked puts, taking advantage of both the expensiveness of the options and the bullishness of a peak in $VIX).

The three peaks in January (on the 2nd, the 16th, and the 28th) were all good short-term buy points. So this coming peak will probably be one as well. Of course, you don't know in advance where $VIX will peak (in 1987, it peaked above 40%!). Using recent action, there has been a relatively good way to define a peak in $VIX: if it trades above 23, then when it subsequently closes below the next integer value, a peak has been established. For example, on Jan 2nd, it traded up to 24 and closed below 22 that same day; on Jan 16, it traded above 22 and then closed below 21 on the 17th; and on Jan 28th it traded above 23 and closed below 22 on Jan 29th. So, since it traded above 23 Wednesday, a close below 22 would be a short-term buy signal. As you can see from recent action, these rallies have been getting shorter and shorter, so use this as a trading guide, but be sure to realize it's a short-term one.

Near-Term Options (Recent History)

FUTURES OPTIONS Table of Volatility Skewing in Futures Options

The table on the bottom of page 6 shows two situations where implied volatility has increased and the volatility skew has steepened as well. One of those contracts is the S&Ps, which is one of the reasons why we recommended the put ratio write there. The other is Orange Juice. We have had call ratio writes in place in this declining market for several weeks. Now, we want to move into May Orange Juice positions since the March options are expiring.

Position F128: Orange Juice ratio spread
Buy 3 May 90 calls
and sell 3 May 100 calls
and sell 3 May 110 calls
for a debit of 1.00 or less per spread
1 point=$150; options expire 4/4/97
JOK: 88.10 May 90 call: 6.00
May 100 call: 3.15 May 110 call: 1.75

Profitability: the downside loss is limited to the amount of the initial debit. The maximum profit will be made if May futures are between 100 and 110 at option expiration, although some profit can be had if the futures are between about 91 and 119 at expiration. The major risk is that May futures rise above 119 before expiration. There is a 13% chance of the futures ever trading at that level by April 4th.

There is also the possibility that, if Orange juice begins to rise and passes through the maximum profit range in a month or so, profits would accrue at that time. That's why we want you to check in if OJ trades at 110.

Investment: Allow $3000 per naked option, or $9000 margin for this model portfolio position.

Follow-Up Action: call the HOTLINE if May OJ trades at 110. Also, as protection against disaster, place a GTC STOP order to buy 3 May futures at 120.

Number in brackets is percent of past implied volatilities exceeded by current reading

The box on the right shows where option implied volatility is either extremely low or extremely high (and in the "high" category, we have attempted to screen out rumors stocks). There are some very interesting items in this list, particularly in futures and index options. First, notice that OEX and S&P 500 options are very expensive on a percentile basis, confirming the commentary on page 6. T-Bond options are also expensive, reflecting the fact that the "unenjoyment" (unemployment) numbers are due Friday. Coffee options are expensive, which is normal after a commodity has run up this far, this fast. The expensive options in both the Japan Index ($JPN) and the Japanese Yen futures are indicative that a bottom will soon form in those markets. When implied volatility rises dramatically in a falling market, the subsequent peak in implied volatility usually marks the bottom of the market (or at least is an excellent time to sell naked puts). That peak has not yet occurred in the yen, but it probably has in the Japan Index (see charts, insert). This may be even more interesting since the put-call ratios are near buy signals in both markets as well. I wouldn't sell any naked Yen puts yet because that market is still collapsing, but you might sell a $JPN put credit spread in anticipation of the breakout that will trigger our call buy (see page 5). On the cheap side, Cocoa and Cotton options remain inexpensive and we continue to recommend the purchase of Cotton straddles (Position F126). Also, Mexico Index ($MEX) options are cheap and straddle purchases could be considered in that market as well.

Position F129: Wheat sell combo
Sell 4 May 380 calls
and sell 4 May 330 calls
for a 9 cent credit
1 point=$50; options expire 4/18/97
WK: 351 May 380 call: 5 May 330 put: 4½

Wheat options are also expensive, and we think represents an attractive sell combo, since the profit range, 321 to 389, surrounds the entire near-term wheat trading range. Allow $800 in margin per naked option sold. Close the position if May wheat trades at 320 or at 390.

There seem to be fewer attractive situations in stock options. In Bristol-Myers and Hewlett-Packard, you might try to sell butterfly credit spreads: attempt to get a 4 point credit if you use a 5-point differential in the strikes. You will have to "middle" the market to get that trade done. On the other hand, Glaxo options look fairly cheap, and you might try purchasing the May 30 puts and May 35 calls both of which are fractionally priced. While there are many stocks whose options are statistically cheap because stock prices have increased, such straddles seem somewhat expensive.

Recent spikes in implied volatility

*: heavy put volume

There are several rumors in the markets lately. One was Paine Webber (PWJ), but when Morgan Stanley and Dean Witter announced they were merging, PWJ fell back some. It's still a general takeover rumor, along with any other brokerage stock. Fleet Financial (FLT), Galoob Lewis (GAL), North American Vaccine (NVX), and U. S. Surgical (USS) all are behaving like takeover rumors, although each has a positive fundamental story "working" also. Perhaps the most interesting development is American Power Conversion (APCC). The stock is in a downtrend. However, for the last six trading days call option volume has ballooned (no puts have traded at all) and implied volatility is skyrocketing (box, above left). Clearly, a major announcement of some sort is at hand, but we haven't found anyone who knows what it is. If the stock were acting better, we'd be certain that it is to be a positive announcement. However, unless the stock can get above 28, it won't have a positive chart. Buying straddles or backspreads is risky because the options are so expensive. We are going to recommend bull spreads in the two stocks that seem to have "something going on".

Position S210: FLT bull spread
Buy 4 FLT Feb 55 calls
and sell 4 FLT Feb 60 calls
for a debit of 1-3/8 or less
FLT: 54¼ Feb 55 call: 1-7/8 Feb 60 call: 3/8

This is a high-risk position because the options only have two weeks of life. Don't establish too large of a position.

Position S211: APCC bull spread
Buy 5 PWQ Mar 30 calls