Traded Options a way to Make Spectacular Profits

Delta Neutral Trading Woes

What is Delta neutral trading? You will often hear that it is the secret to making money no matter which way the market may move. The truth is that being aware of Delta is imperative to good option trading strategies, but it is not the answer to all of your financial woes.

Delta sometimes called the hedge ratio is an option’s sensitivity to movements in the underlying security. When the option is at the money then delta is at its highest. Delta neutral trading is hedging your position against wild market swings by using spread strategies to cancel out the direction the market takes.

One simple way to trade Delta neutral (and to refute its touting as a magical black box system) is to buy a straddle or strangle, or to sell either. This is important, these are both delta neutral strategies, but only one can make money at a time. If I were to buy one strangle (one call and one put at the same strike price) at a $30 strike price for $5 per contract for ABC stock and the stock were to reach $50 at expiration, I would make a cool $1500. That is $5000 income from the call minus the $3000 I would pay for the stock minus $500 I previously paid for the spread. Sound great until I consider the other side, which was also delta neutral. The other side sold the spread for a $500 premium, but at the end of the day lost $1,500 on a perfectly delta neutral trade.

A Delta neutral Die Hard would argue with me on the above example and say they would have made adjustments as to this trade to prevent loss. Basically meaning, they would have bought back the trade and rolled it into a higher strike. Sounds great in theory, however they still have to deal with two issues that plague every small options trader. These are the spread and the brokerage costs of going out of two positions and into two others. If they trade frequently and have an option friendly brokerage firm, this may only cost them $20 for the four ask and bid spreads and $4 for the fees. Most likely it will cost closer to $40 for the spreads (provided the stock isn’t illiquid) and $40 for the brokerage fees. Another fact of life is that stocks have a tendency to be unpredictable. Perhaps the stock moves so fast you don’t have time to adjust you position, or worse yet the stock bounces up and you adjust only to have it bounce back down the next trading session. Now your loss has doubled.

Then what good is Delta? Delta is a great Greek to use in determining the risk reward of any trade. I personally am aware of Delta in all of my positions, whether opening or already active. If I make a directional trade then I want Delta to be positive for my bullish forecasting and negative for my bearish. If I am Delta neutral, then I know I better expect a huge move if buying, a volatility swing, or be selling Theta in order to profit.