Basics of Delta Values & Delta Neutral Positions
The delta value of an option is a measure of how much the price of an option will change when the price of the underlying security changes. For example, an option with a delta value of 1 will increase in price by $1 for every $1 increase in the price of the underlying security. It will also decrease in price by $1 for every $1 decrease in the price of the underlying security.
If the delta value was 0.5, then the price would move $.50 for each $1 move in the price of the underlying security. Delta value is theoretical rather than an exact science, but the corresponding price movements are relatively accurate in practice.
An option’s delta value can also be negative, which will mean the price will move inversely in relation to the price of the underlying security. An option with a delta value of -1, for example, will decrease in price by $1 for every $1 increase in the price of the underlying security.
The delta value of calls is always positive (somewhere between 0 and 1) and with puts it's always negative (somewhere between 0 and -1). Stocks effectively have a delta value of 1.
You can combine the delta values of options and/or stocks that are make up one overall position to get a total delta value of that position. For example, if you owned 100 calls with a delta value of .5, then the overall delta value of them would be 50. For every $1 increase in the price of the underlying security, the total price of your options would increase by $50.
We should point that when you write options, the delta value is effectively reversed. So if you wrote 100 calls with a delta value of 0.5, then the overall delta value would be -50. Equally, if you wrote 100 puts options with a delta value of -0.5, then overall delta value would be 50. The same rules apply when you short sell stock. The delta value of a short stock position would be -1 for each share short sold.
When the overall delta value of a position is 0 (or very close to it), then this is a delta neutral position. So if you owned 200 puts with a value of -0.5 (total value -100) and owned 100 shares of the underlying stock (total value 100), then you would hold a delta neutral position.
You should be aware that the delta value of an options position can change as the price of an underlying security changes. As options get further into the money, their delta value moves further away from zero i.e. in calls it will move towards 1 and in puts it will move towards -1. As options get further out of the money, their delta value moves further towards zero.
Therefore, a delta neutral position won't necessarily remain neutral if the price of the underlying security moves to any great degree.
Profiting from Time Decay
The effects of time decay are a negative when you own options, because their extrinsic value will decrease as the expiration date gets nearer. This can potentially erode any profits that you make from the intrinsic value increasing. However, when you write them time decay becomes a positive, because the reduction in extrinsic value is a good thing.
By writing options to create a delta neutral position, you can benefit from the effects of time decay and not lose anymoney from small price movements in the underlying security.
The simplest way to create such a position to profit from time decay is to write at the money calls and write an equal number of at the money puts based on the same security. The delta value of at the money calls will typically be around 0.5, and for at the money puts it will typically be around -0.5. Let’s look at how this could work with an example.
- Company X stock is trading at $50.
- At the money calls (strike $50, delta value 0.5) on Company X stock are trading at $2
- At the money puts (strike $50, delta value -0.5) on Company X stock are also trading at $2.
- You write one call contract and one put contract. Each contract contains 100 options, so you receive a total net credit of $400. The delta value of the position is neutral.
If the price of Company X stock didn't move at all by the time these contracts expired, then the contracts would be worthless and you would keep the $400 credit as profit. Even if the price did move a little bit in either direction and created a liability for you on one set of contracts, you will still return an overall profit.
However, there's the risk of loss if the underlying security moved in price significantly in either direction. If this happened, one set of contracts could be assigned and you could end up with a liability greater than the net credit received.
There's a clear risk involved in using a strategy such as this, but you can always close out the position early if it looks the price of the security is going to increase or decrease substantially. It's a good strategy to use if you are confident that a security isn't going to move much in price.
Profiting from Volatility
Volatility is an important factor to consider in options trading, because the prices of options are directly affected by it. A security with a higher volatility will have either had large price swings or is expected to, and options based on a security with a high volatility will typically be more expensive. Those based on a security with low volatility will usually be cheaper
A good way to potentially profit from volatility is to create a delta neutral position on a security that you believe is likely to increase in volatility. The simplest way to do this is to buy at the money calls on that security and buy an equal amount of at the money puts. We have provided an example to show how this could work.
- Company X stock is trading at $50.
- At the money calls (strike $50, delta value 0.5) on Company X stock are trading at $2
- At the money puts (strike $50, delta value -0.5) on Company X stock are also trading at $2.
- You buy one call contract and one put contract. Each contract contains 100 options, so your total cost is $400. The delta value of the position is neutral.
This strategy does require an upfront investment, and you stand to lose that investment if the contracts bought expire worthless. However, you also stand to make some profits if the underlying security enters a period of volatility.
Should the underlying security move dramatically in price, then you will make a profit regardless of which way it moves. If it goes up substantially, then you will make money from your calls. If it goes down substantially, then you will make money from your puts.
It's also possible that you could make a profit even if the security doesn't move in price. If there's an expectation in the market that the security might experience a big change in price, then this would result in a higher implied volatility and could push up the price of the calls and the puts you own.
Provided the increase in volatility has a greater positive effect than the negative effect of time decay, you could sell your options for a profit. Such a scenario isn't very likely, and the profits would not be huge, but it could happen.
The best time to use a strategy such as this is if you are confident of a big price move in the underlying security, but are not sure in which direction. The potential for profit is essentially unlimited, because the bigger the move the more you will profit.
Hedging
Options can be very useful for hedging stock positions and protecting against an unexpected price movement. Delta neutral hedging is a very popular method for traders that hold a long stock position that they want to keep open in the long term, but that they are concerned about a short term drop in the price.
The basic concept of delta neutral hedging is that you create a delta neutral position by buying twice as many at the money puts as stocks you own. This way, you are effectively insured against any losses should the price of the stock fall, but it can still profit if it continues to rise.
Let’s say you owned 100 shares in Company X stock, which is trading at $50. You think the price will increase in the long term, but you are worried it may drop in the short term. The overall delta value of your 100 shares is 100, so to turn it into a delta neutral position you need a corresponding position with a value of -100.
This could be achieved by buying 200 at the money puts options, each with a delta value of -0.5. If the stock should fall in price, then the returns from the puts will cover those losses. If the stock should rise in price, the puts will move out of the money and you will continue to profit from that rise. There is, of course, a cost associated with this hedging strategy, and that is the cost of buying the puts. This is a relatively small cost, though, for the protection offered.
