Delta-neutral trading strategies
By Simon Gleadall, CEO of Volcube.
What is a delta-neutral strategy?
A delta-neutral strategy aims to make a profit regardless of the price moves of the underlying asset. For example, a trading strategy that uses gold derivatives (gold futures, gold options, gold variance swaps etc.) would be a delta-neutral strategy if its success or failure was independent of the actual price of gold.
To create a delta-neutral strategy, the trader either needs to make sure that the delta risk associated with each element of his portfolio is offset in total. Or he needs to aggregate the delta risk from his position and then delta hedge the portfolio as a whole. For example, a trader may own a call with a 20% delta and also own a put with a -20% delta. This is known as a strangle and in this case it is delta-neutral (because the deltas from the call and the put cancel one another out). If say the put only had a -12% delta, the strangle as a whole would have an 8% delta [20% + (-12%) = 8%]. To make this strangle delta-neutral, the trader needs to sell the underlying product in the correct ratio. Or he needs to hedge in some other way, perhaps by selling call options or buying more put options.
How do you make money from a delta-neutral strategy?
At first glance, you might think that a delta-neutral strategy is just a neutral strategy and that it won’t ever make or lose money. This is not the case. The reason is that the price of the underlying is only one of several factors that affect the value of derivatives struck on the underlying. A delta-neutral strategy removes the risk that is due to the underlying price moves, but it does not hedge or neutralise the other risks that derivatives face. For example, an options portfolio might be delta-neutral and so it is not exposed to moves in the underlying price, up or down. BUT, it may still be exposed to the expected volatility in the price of the underlying. Likewise, options can be exposed to the risk associated with time decay.
Traders look to make money from delta-neutral strategies by focussing the risk of their portfolio in areas where they think they have an edge. For example, an options market maker or volatility trader will usually not think he has any edge or advantage over other market players in the price of the underlying. A market maker in gold options will probably not think of himself as being especially good at trading the actual price of gold. More likely is that the options market maker thinks he has an edge in trading delta-hedged options. In other words, he thinks he can make money by trading the non-delta factors that affect option values. The most important of these is the implied volatility. By delta hedging, an option trader shifts the risks associated with options from being about the direction of price moves to the expected volatility of price moves.
Learn to trade delta-neutral strategies
When you use the Volcube options market simulator you can practise delta-neutral trading strategies. To make this easy, Volcube allows you to use an auto-hedger which will delta-hedge all your option trades automatically. This lets you focus on trading delta-hedged options in the simulations and learn about how to make money from delta-hedging positions.
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BA Economics, Northwestern University
& Trainee derivatives trader in Chicago