Investors spend a lot of time thinking of ways that they can mitigate risk while still earning money. The delta neutral strategy stands out as one of the most popular ways for beginning and advanced traders to lower their risks.
Explaining delta neutral trading often gets complicated because experts want to use detailed examples. Unless you have years of experience, though, you need a straightforward explanation that doesn’t use a lot of fancy terms.
First, let’s address the term “delta.” In Greek, the word “delta” means “change.” Investors use it in a similar way, today. When they talk about an option’s delta, they’re talking about the positive or negative change in that option’s value.
With delta neutral trading, we apply the term “delta” to several stocks, options, and even futures in your portfolio. The idea is to offset negative deltas with positive deltas to reach balance in the portfolio.
How do you do this?
Delta Neutral Trade Example
Let’s look at a very simple example. If you have 100 shares of stock in your portfolio that you own with a delta of +100, you can reach delta neutrality by purchasing two put options that have deltas of -50.
You can’t always ensure that your delta neutral trading strategy will reach zero.
Ideally, you try to come as close to zero as possible.
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How Do Delta Neutral Strategies Make Money?
When you first learn about delta neutral strategies, you probably stop and wonder how they can make money. If you’re always striving to reach zero, how can your portfolio generate profits?
Delta neutral strategies provide various ways for traders to make money.
One common strategy encourages you to move away from delta neutrality when you spot a swing in the market. If your portfolio is completely neutral, then you can quickly take advantage of price increase and decreases.
An investor who has committed to a positive or negative strategy doesn’t have as much flexibility. He or she is locked into the market’s whim. With delta neutrality, you can change your investment strategy immediately to make money regardless of whether the market moves up or down.
You can also make money from delta neutral strategies by using a collar trade. Let’s say you own 100 shares of long stock. You can also add one long put and one short call. In this situation, you can expect the combination of bearish options to protect you from loss.
If the 100 shares fall in value, the short call and long put should increase in value.
Having the option to exercise your put option makes it possible for you to either earn money or walk away with a small loss.
Another way delta neutral traders make money is through selling time value. Initially, a trade could be structured as delta neutral but as time goes by the theta decay on short options could possibly earn the trader income.
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Why Apply Delta Neutral Hedging?
Investors cite several reasons to delta hedge. Some of the most common reasons include:
- Maintaining periods without directional bias so you can make a quick decision at the right moment.
- Temporarily hedging a position until you know enough to make an informed move.
- Protecting profits or locking in profits.
- Stop portfolio losses before they become significant.
You might notice from this list that some advantages apply to experienced traders while others apply to beginners.
If you don’t have a lot of experience trading, then you can use a delta hedge to watch the market move and learn about investing features without jeopardizing much money. Basically, you get a cheap way to learn a lot about investing in stocks, options, and futures.
Experienced investors will often put delta hedges in play when they realize that the market isn’t behaving as expected.
Perhaps a media story has forced a stock’s value to plummet. When this happens, going into delta hedge mode prevents previous gains from flowing out of your portfolio. You will probably lose some money, but you can gain some control over the loss.
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What Is a Delta Neutral Straddle?
If you’re already familiar with the concept of “straddling,” then you can probably guess the meaning of “delta neutral straddle.”
When you straddle, you buy or sell either a call or put option with the same price and expiration date. As long as the option moves a certain amount, either up or down, you will make money from the deal. It’s an example of how you can make money from market volatility instead of betting that a stock’s value will increase.
With a straddle, you don’t care whether an option increases or decreases in value. You just believe that it’s overpriced or underpriced.
A delta neutral strategy combines straddle and delta neutral concepts. When you use this strategy, your purchases offset each other to reach a zero delta (more often than not, you end with 0.5 or -0.5 delta, but you do your best).
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What Does Negative Delta Mean?
Delta Neutral Portfolio: If you don’t offset your risk with opposite options, then you could fall into a negative delta. A negative delta means that the change in value is less than zero.
You can still make money from a negative delta strategy, especially if you try to utilize a neutral delta straddle. You do, however, accept a little more risk. More often than not, investors want to remain on the positive side.
Several online platforms will let you use neutral delta strategies. Look for an option that meets your expectations so you can see how it works for you.
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How To Trade Trade Delta Neutral Strategies
Not all brokers are made equal so if you are planning to trade delta neutral trading strategies, picking a platform that specializes in options is a must.
tastyworks or thinkorswim are both excellent choices. They rank among the best options trading platforms for trading delta neutral and other complex trades.
Both options platforms were built by teams of expert options traders so you can be confident that if you want to view a delta neutral risk graph, place delta neutral trades or simply want fast and accurate order execution they’ll both live up to your expectations.
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