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Tuesday, February 14, 2012

Profitting from Delta Neutral trading

How to trade delta neutral and still profit from it?
At first I didn't even know what the hell Delta meant, let alone did I question how to make a profit Delta neutral trading. Anyways, according to Investopedia:


Definition of 'Delta'

"The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. Sometimes referred to as the 'hedge ratio'."


Got it?!?! Sure you did!! If you didn't, things are simpler in my world.
If you trade options, the Delta of the option means how much money the option wins or losses per every point of movement in the stock.

For example let's say you are considering to buy an IBM February 190 Call.

(Click on image to enlarge)
 
You could buy that Call option for $234 or less. With a Delta of 0.42, if IBM moves one point in your favor (that is upwards) The Call should increase $42 in value. If IBM loses one point the Call should lose $42 in value. Once the move occurs the Delta of the Option changes. It will increase if the movement of the stock was in your favor or it will decrease if the movement was against you. A Put on the other hand will give you negative deltas, that is, you make money if the stock goes down. When options are at the money or close to it, they have a delta of around 0.50 (+50 deltas for Calls and -50 deltas for Puts).

Now, unlike options, when buying stock your Delta is 1 per share. So for example 100 shares of IBM will mean you are positive 100 deltas. If IBM moves up $1 you make $100, if IBM loses $1 you lose $100. Unlike options, the deltas of your stock position don't change, as long as you own 100 shares you will be +100 delta positive.

Using Delta Neutral trading to extract profits form the markets
The objective of Delta Neutral trading is to remove price risk, also known as directional risk and be profitable regardless of stock movement as long as it moves somewhere and doesn't stay in the same place. The Delta neutral technique is achieved by combining options and shares so that your overall delta is as close to zero as possible.

Let's say company XYZ is trading at $100. You buy 100 shares of company XYZ. That is +100 Deltas. You need -100 Deltas to offset the +100 risk. By buying 2 at the money PUTs (remember the at the money options have around 50 deltas) you should be close to -100 deltas which offsets the initial +100 Deltas. Let's say the at the money Puts are worth 5.00

Buy 100 shares XYZ at $100 (+100 delta)
Buy 2 At the money PUTs at $5.00 (-100 delta)

You invested $10,000 in the stock and $1,000 in the Puts. Total investment $11,000.

What happens now is that if the stock moves up by one point, you are making $100 with your shares, but you lose $50 with each Put (because of their -50 deltas), so $100 lost in total for the Puts. However, the delta of your Puts decrease as the stock moves against them. After the movement, the Puts are not out of the money anymore and therefore their delta is not 50 anymore. Let's assume delta is now negative 40 per Put. If the stock moves up another point you make $100 again in your shares position but this time you lose only $80 on your Puts ($40 loss on each Put per the -40 deltas). Now you already have a small profit overall as you gained more in the stock than what you loss with your Put options.

If the stock keeps moving up you make $100 on your shares position for each point of move and you lose less and less on your Put options, resulting in greater profits. You keep making the same money on your shares moving up, while your Puts lose less money than what you are making on your shares.

Back to out XYZ example:
Let's say XYZ moves from $100 to $105. Your Puts are now five points Out of the Money and instead of $5.00 they are now worth $3.00 (time value left) and have a Delta of 0.35. That means you have $600 in your Puts with -70 Deltas. You also have $10,500 of value in your shares, with still +100 Deltas. Overall you went from a delta neutral position to positive 30 deltas.

100 shares of XYZ at $105 = $10,500  (+100 Deltas)
2 Puts Strike $100 at $3.00 = $600       (-70 Deltas)

Combining both components of the position you now have $11,100 and +30 Deltas. There is a $100 profit on the initial amount of $11,000 invested. You can close the whole position now and go home with $100 or you can re-balance your deltas and get back to neutral. Having +30 deltas, you can reduce that excess by selling 30 shares (-30 deltas). You can also buy a new Put with 0.30 negative deltas. Let's say we decided to use the first approach and we sell 30 shares.

30 shares sold at $105
still own 70 shares at $105 (+70 deltas)
still own 2 Puts at $3.00 and 0.35 negative deltas (-70 deltas)

If XYZ keeps moving up you make more money. Let's say XYZ moves up now from $105 to $110, you make $5 on 70 shares. That is a $350 gain, however you lose less than $350 on the Puts as your negative 70 deltas only affect the Puts at the very beginning of the stock movement, and it starts to go down after that. Let's say you lose $250 on your puts, that's another $100 in profit overall. Then again, you re-balance it all back to delta neutral or close the whole thing.

Let's analyze the case when the stock starts to move down.

What happens now is that if the stock moves down by one point, you are losing $100 with your shares, but you gain $50 with each Put, so $100 won in the Puts. However, the deltas of your Puts increase as the stock moves in their favor. So instead of 50 negative deltas per Put, let's assume it is now 60 negative Deltas per Put. If the stock moves down another point you lose $100 again in your shares position but this time you make $120 on your Puts ($60 profit on each Put per the -60 delta). If the stock keeps moving down you keep losing $100 on your shares position for each point of move and you win more than $100 over and over again as your Puts deltas combined is greater that 100. And this results in an overall profit. You keep losing the same money on your shares moving down, while your Puts make more money than what you are losing on your shares.

Buy 100 shares XYZ at $100 (+100 delta)
Buy 2 At the money PUTs at $5.00 (-100 delta)


You invested $10,000 in the stock and $1,000 in the Puts. Total investment $11,000.


XYZ moves from $100 to $95. Your Puts are now five points In the Money and instead of $5.00 they are worth $11.00 and have a Delta of 0.65. That means you have $9,500 invested in your shares, with +100 Deltas and $2,200 in your Puts with -130 Deltas.

100 shares of XYZ at $95 = $9,500   (+100 Deltas, 1 delta per share)
2 Puts Strike $100 at $11.00 = $2,200 (-130 Deltas)

Overall you now have $11,700 and -30 Deltas. You have made $700 in profit. You can close the whole position now and go home with $700 or you can re-balance your deltas and get back to neutral. Having -30 deltas, you can remove that by buying 30 more shares this time at $95. Or you can get rid of one of the Puts and sell shares at the same time like this:

Sell 1 Put at $1,100 and 35 shares at $95.
still own 65 shares at $95 (+65 deltas, +1 delta per share)
still own 1 Put at $11.00    (-65 deltas)

That way you can lock in profits little by little and go back to Delta neutral every time your overall deltas are far from zero.

Note: Although I have exemplified the technique with the Purchase of stocks and Puts, it can also be done shorting stocks and buying Calls. The principle is the same: re-balance to delta neutral from time to time and lock in profits in the process.



Weakness

Until now, it all sounds too good to be true and it is. This strategy has its weak points:

1- If the stock doesn't move, the options will lose value due to time decay while you gain nothing on your shares, resulting in overall loss.

2- In practice the price of options is not so predictable as Delta is not the only factor that affects it. You also have implied volatility which is a major concern, plus time decay (known as Theta) mentioned above.

3- In case you become a master at Delta Neutral trading, while it is true that the risk of huge losses is minimum, the returns on the overall investment are also small. So, for the average retail trader with a 10 thousand dollar account, it is not worth the time.


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4 comments:

  1. I appreciate this great article very unique and informative thanks.

    ReplyDelete
  2. Hi, how much profit how fast do you think a good DN trader could make with 10k ? Could you mail the answer to me? nicobottema@gmail.com

    ReplyDelete
  3. No quick get reach formula here pal.
    Regardless of the system, a trader who is able to achieve 20% portfolio growth in a year, is a great trader.
    Delta neutral trading takes nerves and patience

    Cheers,
    LT

    ReplyDelete