If trade options long enough, eventually you will hear about the ‘Greeks.’ No, I’m not talking about the beaches of Santorini… no sir… you need to plug in a partial differential equation to understand these Greeks.
And while it might sound intimidating… even overwhelming when you first come across them…
While understanding and learning the Greeks isn’t essential…It can help you make better decisions and give you an edge in your trades.
The Options Greeks tell traders how the different pricing factors affect their position: the price of the underlying stock, time to expiration, and volatility are an example.
Today, I’m going to teach you about one of the most important Greeks—Delta.
Delta tells traders how much their position is affected by the changes in the underlying stock price move.
It helps us answer questions like: which option should I buy.
When you buy a share of stock, every one dollar movement in price moves the price of that share by one dollar. Options don’t work the same way. They move anywhere between -1 to +1 based on a one dollar movement in the underlying stock price.
Puts will always move between -1 and 0. As the price of a stock increases, the value of a put decreases.
Calls will always move between 0 and 1. As the price of a stock increases, the value of a call increases.
Two major components influence Delta – the strike price and the time to expiration.
The distance between the strike and the current price dictates Delta. As an option gets further out-of-the-money, the less it moves in response to a change in the stock’s price. Deep in-the-money options approach +1 or -1 the further in-the-money they go.
As we get closer to expiration, the sensitivity becomes more linear (a straight line) rather than a curve.
Here’s what the delta looks like for a call option where the current price of the stock is $55.
Fun fact – The rate of change of Delta is known as Gamma. Think of Delta as the speed of a car and Gamma as the acceleration/deceleration.
Option Delta is 0.5 for at-the-money call options and -0.5 for put options.
Changes in volatility also affect option delta. When volatility (Vega) increases, it stretches out the lines above. The new option price is costlier because it includes a heavier weight of volatility. So, Delta loses its influence.
Creating a Delta Neutral Portfolio
Neutral portfolios require constant adjustment. Remember that delta changes over time for your trades. Each trade’s delta changes at different rates. That means you could be neutral one day and either positive or negative the next.
There are a few options to offset deltas in your trade:
- Buy or short sell stocks
- Increase or reduce your option positions
- Buy or sell futures positions
Which option you choose depends on your comfort level and experience, as well as the amount of Delta you need to offset. You probably don’t need to adjust a portfolio with 5 Deltas that contains 20 positions. It just isn’t worth it.
Creating a neutral portfolio starts with an understanding of volatility of each stock and its price. While each contract holds 100 shares, not all will act equal.
For example, a $330 stock can swing around $5 in a typical day, which is only 1.5%. However, a $30 stock could swing 10%, but that’s only $3. I look at the implied volatility of the stock as well as the historical volatility. Then, I multiply that by the share price to get a sense of the delta.
It’s also important to look at which stocks you choose. I prefer to pair off stocks in the same sector based on relative performance. For example, I would bet against Netflix by selling a call spread while going long Paypal by selling a put spread.
The key to a profitable neutral portfolio
Delta neutral portfolios work best when you try to make your profits from time and volatility decay. This involves selling options against stocks, whether naked or as part of a spread.
Profiting of volatility decay means waiting until implied volatility reaches relatively high levels and betting on mean reversion. Time decay works by selling options around 30-45 days out and then taking them off at 50% of maximum profit.
I love strategies like this. That’s why I use them every week in my Total Alpha service. They pay consistent income while reducing my risk. It’s a great strategy no matter your skill level.
Come join me at Total Alpha, where you can learn how to create consistent paychecks.