Options: Delta Neutral Trading Tips

By: Paul Forchione

The following is taken from Paul Forchione Trading Options Visually

Neutral options trading generally refers to Delta Neutral options trading.  The Delta of an option is defined as the amount the options price moves in relation to a one point move in the underlying commodity.  So, an option that moves .65 points for a one point move in the commodity has a Delta of 65 or 65%. An options pricing model is needed to calculate the Delta of each option, and calls have positive Deltas while puts have negative Deltas.

A Delta Neutral position is an options spread having a net Delta close to zero.  This means one side of the spread favors price increases in the underlying commodity while the other side of the spread favors price decreases.  Overall, a Delta Neutral spread is expected to neither make nor lose money when there are small price changes in the underlying commodity.

Option prices are directly affected by implied volatility expansion and contraction.  This is another way of saying that option prices fluctuate with changing expectations for future volatility of the underlying commodity.  When market sentiment anticipates volatile asset prices, option premiums rise, and when sentiment expects a quiet period for commodity prices, option prices fall.

The goal of a Delta Neutral trader is to buy options when they are “cheap” (when implied volatility is low from a historical perspective) and sell options when they are “expensive” (when implied volatility is high from a historical perspective) because eventually volatility will return to a more normal level.

Delta Neutral Trading Tips

Professional options traders think in terms of spreads and they hedge themselves to stay neutral on market direction.  Direction of the underlying commodity is less important to them than volatility of the options (implied volatility) and volatility of the underlying commodity (statistical volatility).

Professional options traders also let the market tell them what to do.  They recognize the market is saying the appropriate strategy is to sell premium when option implied volatility is high (options are expensive).  Conversely, they understand the market is saying the low risk strategy is to buy premium when implied volatility is low (options are cheap).

The most difficult aspect of Delta Neutral options trading is learning to stay focused on volatility.  The reason it's psychologically hard to trade on volatility considerations is because it's natural to look at a price chart, draw conclusions about futures market direction, and be tempted to bias your position in the direction you feel prices will move.

The point of neutral trading, however, is that you want to make money based on how accurately you forecast volatility and you don't want to run the risk of losing money because you’ve incorrectly forecast market direction.  That’s why you should initiate your spreads Delta Neutral and also why you should adjust them back to neutral if they later become too long or short…which brings us to the second most difficult aspect of Delta Neutral options trading:  Acting without hesitation when the market tells you to act.

So if your position becomes too long or short, you must mechanically adjust without hoping for price to move in the direction of your Delta bias.  While it's natural to want to "give the market a chance to go your way," the fact of the matter is that the market has already proven you wrong, so it would be only wishful thinking to expect it will suddenly move the way you want.  Every Delta Neutral trader knows the feeling of having a weight lifted from his shoulders the moment he does the right thing by executing an adjustment to get neutral.

When you buy premium, be prepared to take action if the market makes a big move so you can "lock-in" profits.

When you sell premium, don't expect volatility to collapse right away.  You'll probably need to be patient.  You hope the commodity won't move around a lot while you're waiting.  However, time decay helps you while you're waiting.

Don't expect huge profits on any neutral option spread.  A properly implemented Delta Neutral program will result in some "strike-outs," a lot of "singles," and an occasional "double" or "triple."  Just remember you should hold positions only while volatility is out-of-line.  You may need to adjust your position several times because it became Delta long or short.  However, you should close your positions when there's no edge remaining.

Resist the desire to be a naked seller close to expiration.  The rewards can be attractive because time decay rapidly accelerates the closer you get to expiration, but there's no limit to the losses you could sustain if the market moves through the strike price of the short options and you don't quickly close or adjust your position.