- 2000: Volume 9, No. 5 Puts & Calls: Delta Dollars

Many times when you read or hear seasoned traders discussing their strategies, you will notice that they refer to trades or positions that are non-directional or delta neutral. This terminology can be confusing and sometimes intimidating to those who have not been exposed to this type of trading and rhetoric. When broken down, this is a very simple concept, yet extremely powerful, that can be incorporated into a trading plan to help reduce your risk exposure, ease your stress levels, and increase your overall profitability as a trader. Let's review some of these basic concepts and how they might be integrated into your own trading approach.

First, why would anybody want to place a non-directional or delta neutral trade? One reason is that the trader does not know which direction the market is going to take; however, they may feel that it is going to move big time one way or the other. Another reason that these types of trades are implemented is strictly for protection. For example, say your gut tells you Nortel Networks (NT) is going to break out one way or the other but you do not know which direction it is going to take...implementing a delta neutral trade may be just the right strategy to take.

What do you need to know to trade in this manner? First, you must have an understanding of the concept of "delta". Delta is a Greek term that describes the amount by which the price of an option changes for every dollar move in the underlying stock. For example, if a call option has a delta of 0.5, that implies the option will increase by $.50 for every $1.00 that the underlying stock moves higher.

Secondly, varying deltas are assigned to different financial instruments. A stock has a fixed delta of plus or minus 1. If you are long 100 shares of stock, you have +100 deltas. If you are short 100 shares of stock, then you have -100 deltas. No matter what happens to the price of the underlying stock, it always has plus or minus 100 deltas. Options, on the other hand, have variable deltas. That is, the deltas change in relation to movement in the underlying stock. A call option has a positive delta if you are long the call, and it has a negative delta if you are short the call. A put option has a negative delta if you are long the put, and it has a positive delta if you are short the put. The basic idea that you need to understand is that a position with overall positive deltas will benefit from an increase in the underlying asset, a position with overall negative deltas will profit from a decrease in the underlying instrument, and a position with "0" deltas (delta neutral) will not matter which direction the security moves in order to be profitable.

Note: Although understanding the basics of deltas can help you to create delta neutral trades, it's basically mandatory to have a computer with an options software package in order to analyze this information.

Long Synthetic Straddle

Getting back to the NT example, how could we incorporate a delta neutral (non-directional) trade using this stock? Again, our assumption is that this stock is going break out in one direction or the other, but we don't know which way. One possibility would be to buy the stock (positive deltas) and then buy some puts (negative deltas) to protect the stock. How many puts should we purchase? We will look to the overall position delta for the answer. Let's say we place a long synthetic straddle by purchasing 1000 shares of NT and buying 20 Jan. 2001 85 puts. The Greeks and position delta of this trade are shown in Figure 1.

Figure 1: Greek calculations for Long Synthetic Straddle Trade

The delta calculation in Figure 1 represents the overall position delta of the trade being discussed. The trade's overall position delta is calculated by subtracting the negative deltas from the positive deltas. The long 1000 shares of stock have a positive delta of +1000 (1 x +1000) while the 20 long puts have a delta of -950 (2000 x -0.475 = -950). Thus, the overall position delta is +50. This means that for every dollar NT goes up, this position will gain $50.00. This is about as close to delta neutral as you can get; however, the slightly positive delta implies that a bullish bias is built into this trade. If the position delta was zero, then the trade would be completely non-directional, meaning that all of the directional risk has been eliminated from the position. Lastly, if the position delta was negative, then a bearish bias would have been built into the trade.

The graph in Figure 2 shows the risk profile of the long synthetic straddle trade. The dashed lines show what happens to the position as time passes. The risk profile shows us that as long as the stock rises above or below the trade's breakevens, the trade is profitable. The risk that is faced with this position is price stagnation-if the stock stays the same, then losses begin to accrue.

Figure 2: Greek calculations for Positive Delta Position

Bullish Delta Position

Let's try another example using NT. Now we will assume that NT will be going higher, but we do not want to get hurt too badly if our assumptions are proven wrong. We buy 1000 shares of NT and purchase 15 Jan. 2001 85 puts. Instead of buying 20 puts, we will only purchase 15 puts. The position delta and Greeks of this trade are shown in Figure 3.

Figure 3:

You will notice that the position delta is larger in this trade than it was in the first trade discussed. The reason for this is that there are less puts in this trade, which decreases the negative deltas. Once again, we are long 1000 shares of stock for +1000 deltas (1 x 1000). But this time since we are only buying 15 puts, thereby reducing the negative delta to -712.50 (1500 x -0.475 = - 712.50). Since 1000 - 712.5 = 287.50, the overall position delta is +287.50. This means that for every dollar NT goes up, this position will gain $287.50. This trade has more of a bullish bias built into it than the first trade, and that can be recognized immediately by looking at the positive position delta.

The graph in Figure 4 shows the risk profile of the trade, and the dashed lines show what happens to the position as time passes. The risk profile shows us that as the stock goes higher we become profitable, and as the stock falls we don't get hurt too badly. Actually, if the stock were to crash, then the position would have a chance at making money. The risk that is faced with this position is the same as in the first example, price stagnation. As you can see, if the stock stays the same, then losses begin to accrue.

Figure 4:

There are many different ways to construct non-directional trades other than these two examples. Whatever your market assumptions are, you can create a position that will profit if you are right; yet still protect you in the event you are wrong. For example, if you wanted a bearish bias built into the trade, then you could have purchased more puts in order to get an overall negative delta. The best way to determine how to construct the trade that meets your market assumptions is to look at different combinations in an options software package. By allowing the computer do all the calculations and the grunt work, you can spend your time deciding the best type of trade to place.

If you are able to master the concepts discussed above, then you will notice that your confidence in trading the markets will rapidly increase and so will your profits. The adjustments that can be made to these positions really make this type of trading fun and having fun is the primary goal of trading, besides making money. For more information on these kind of trading strategies, take a look at the www.optionetics.com Web site where a host of valuable services and products can be found to help you empower yourself through options education.

Good luck hunting trades!

Phillip Wiegand is a senior writer and options strategist for www.optionetics.com