fbpx Q&A: Delta Neutral Positions (08:16) | Option Strategist

Q&A: Delta Neutral Positions (08:16)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 8, No. 16 on August 26, 1999. 

Questions & Answers

Q: I would like to ask you about delta neutral trading which I have heard and read about. Could you give me a brief description, it's merits and drawbacks, and in what situations it is best used. K.T. 6/17/99

A: In addition to what I’m going to say here I suggest that you read one or both of my books – Options As A Strategic Investment and/or McMillan On Options – for a more in-depth discussion of this subject.

Essentially, a delta neutral position is a hedged position in which at least two securities are used – two or more different options, or at least one option plus the underlying. The deltas of the two securities offset each other so that the position starts out with a "position delta" of 0. Thus, in theory, there is no price risk to begin with – it is neutral with respect to price movement of the underlying. That definition lasts for about a nanosecond.

As soon as times passes, or the stock moves, or implied volatility changes, the deltas change and therefore the position is no longer delta neutral. Many people seem to have the feeling that a delta neutral position is somehow one in which it is easy to make money without predicting the price direction of the underlying. That is not really true.

Delta neutral trading is not "easy": 1) either you assume some price risk as soon as the stock begins to move, or 2) you keep adjusting your deltas to keep them neutral. Method 2 is not feasible for public traders because of commissions. It is even difficult for market makers who pay no commissions. Most public practitioners of delta neutral trading establish a neutral position, but then refrain from adjusting it too often. For example, we recommend straddle buys quite often – normally starting out with a more or less delta neutral position. However, as soon as the stock starts to make a (big) move, we go with the trend – forsaking neutral trading for directional trading at that point.

The biggest mistake that novice traders make with delta neutral trading is that they will short options in a neutral manner – figuring that they have little exposure to price change because the position is delta neutral. However, a sizeable move by the underlying (which often happens in a short period of time) ruins the neutrality of the position and inevitably costs the trader a lot of money. A simple example: if one sells a naked straddle with the stock initially just below the strike price, that’s a delta neutral position. However, the position has naked options on both sides, and therefore has tremendous liability.

In practice, professionals watch more than just the delta – they also watch the gamma, which is how much the delta changes when the stock moves. Something like a short naked straddle has a large negative gamma – indicating that it has large risks if the stock makes a quick move. So, if you really want to be a neutral trader, try to establish positions that are neutral with respect to both delta and gamma – not easy, but not impossible. Even then, price and volatility changes can cause problems.

 

This article was originally published in The Option Strategist Newsletter Volume 8, No. 16 on August 26, 1999.  

The Option Strategist Newsletter $29 trial

Share this

Option Strategist
Blog Search

Trading or investing whether on margin or otherwise carries a high level of risk, and may not be suitable for all persons. Leverage can work against you as well as for you. Before deciding to trade or invest you should carefully consider your investment objectives, level of experience, and ability to tolerate risk. The possibility exists that you could sustain a loss of some or all of your initial investment or even more than your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and investing, and seek advice from an independent financial advisor if you have any doubts. Past performance is not necessarily indicative of future results.
Visit the Disclosure & Policies page for full website disclosures.

-->