How to make money with options no matter which way the market moves with delta neutral trading

One of the most exciting things about buying and selling options is the opportunities they provide the watchful trader to structure trades with profit potential regardless of market direction.  A number of techniques have been developed to provide such opportunities, some difficult to master and some very simple.

These market neutral trading strategies all depend fundamentally on the delta of an options contract.  There is a lot of math we could cover to get a solid grasp on this measurement, but for our purposes here is what you need to know to successfully use it in trading:

Delta is a measurement indicating how much the price of the option will move as a ratio of the underlying’s price movement.  An ‘at the money’ (meaning the price of the underlying stock is very close to the option’s strike price) contract will have a delta of approximately 0.50.  In other words, if the stock moves $1.00 up or down, the option will about $0.50.

Note that since options contracts control an even lot (100 shares) of stock, the delta can also be looked at as a percent of match between the stock and the option contract.  For example, owning a call option with a delta of .63 should make or lose 63% as much money as owning 100 shares of the stock would.  Another way of looking at it: that same call option with a delta of .63 will make or lose as much money as owning 63 shares of the stock.

How about put options?  While call options will have a positive delta (meaning the call will move up when the stock moves up and down when the price of the stock moves down), put options will have a negative delta (meaning the put will move in the OPPOSITE direction of its underlying).  Because market neutral trading strategies work by balancing positive and negative deltas, these strategies are often referred to as ‘delta neutral’ trading strategies.

One last note about delta: this measurement isn’t static.  As the price of the underlying stock moves closer to or further from the strike price of the option, the delta will rise and fall.  ‘In the money’ contracts will move with a higher delta, and ‘out of the money’ contracts with a lower delta.  This is vital, and as we’ll see below, taking advantage of this fact is how we can make money whether the market goes up or down.

 

With this information in hand, we can create a simple delta neutral trading system which has a theoretically unlimited profit potential, while keeping potential loss strictly controlled.  We do this by balancing the positive delta of a stock purchase against the negative delta of a put option (or options).

Calculating the delta for an options contract is a bit involved, but don’t worry.  Every options broker will provide this number, along with some other figures collectively known as the greeks, within their quote system.  (If yours doesn’t, get a new broker!).  With that data, follow these steps to create a delta neutral trade:

  1. identify the stock you wish to place a delta neutral trade with
  2. find the closest option strike price for a contract with an expiration at least three months from now (you can theoretically use any strike price for this technique, but stick with at-the-money strikes for now)
  3. find the delta value from the options quote screen for the put contract you are going to purchase (put delta is actually listed as a negative number)
  4. purchase the put contract
  5. purchase enough stock to offset the put’s negative delta

You are not limited to a single put option with this; just make sure you purchase enough stock to offset whatever negative delta you have taken on with the put purchase.  Example: at the time of this writing, the QQQQ ETF is trading just a bit over $45.  The delta of the 45 put (three months out) is -.45.  I could purchase a single put and balance the delta by purchasing 45 shares of the Qs.  If I wanted a larger position, I could purchase two puts and 90 shares of Qs, or three puts and 135 shares of the Qs; so long as the ration of 45 shares of stock to 1 put contract is established, you can size it appropriately to your portfolio.

This is a very safe position.  As the stock moves up or down, the put contract will move about the same amount in the opposite direction.  The position is hedged so that small market moves will not greatly impact its total value.

This is where the fun starts: remember the point made earlier about delta not being fixed?  As an option becomes more in-the-money, it’s delta gets bigger (or more negative, in the case of a put contract).  If the stock moves the other way and the option becomes more out-of-the-money, the delta moves closer to zero.  For clarity, let’s look at two basic scenarios.

  • Stock moves UP: the put’s negative delta moves closer to zero.  In this situation, the loss in value of the put contract slows resulting in a net profit for the entire position.
  • Stock moves DOWN: the put’s negative delta becomes more negative, so as the stock portion of the portfolio declines in value, the put’s value is increasing at an accelerating rate.  The result is a net profit in portfolio.

Pretty great, isn’t it?   Making money regardless of whether your stock goes up or down; it almost seems like magic.  HOWEVER – while it doesn’t matter whether the underlying moves up or down, it DOES have to move somewhere.  If it just sits there, you will lose the time value of your option, incurring a loss.  To see a great way of limiting that risk, visit my blog at http://timoroustrader.com/blog1/2010/06/08/how-to-make-money-trading-options-regardless-of-market-direction-volatility-and-market-neutral-trading/.   There I will cover another important piece of a well rounded market neutral trading strategy, making sure you have the odds in your favor.

Stay timid!

Timothy McCready

Friday, August 12th, 2011 Uncategorized

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