An Introduction to Delta Hedging

If you have traded options before, you may have heard the term delta hedging. The most followed analytical variables for options are delta, theta, vega, rho and gamma. Delta is the Greek symbol for change, and in finance, the term means the price sensitivity of the option in regards to the underlying instrument.

 

Delta hedging is a technique used by professionals who trade options on a daily basis because trading in an options pit requires many transactions; the total delta is the entire exposure of the professional trader.

Delta Value

The meaning of delta neutral is a delta of 0, which means that no matter how the underlying instrument moves, the options will not change in portfolio value.

One better interpretation of the delta is the probability of its being in the money. If it is an at-the-money option, most likely it will have a probability of 50 percent for being in the money. Normally, an at-the-money delta is 0.50.

The way to balance the delta is to buy and sell call and put options, whichever is favorable. The calls have positive deltas, and the puts have negative deltas. Take, for example, the options trader who has an entire portfolio with the delta equal to 2.25. The call option that would make this portfolio delta neutral could be, for instance, the one with a delta of 0.75. What should the options trader do? In this instance, the options trader should write three of these 75 percent delta calls. What about a put option with a 75 percent delta? Well, in this instance, he would buy three of these puts.

Professional traders use the analytical tools to stay up to date as the market moves during trading hours. That means during mid session if the delta were, for example, 0.03, the trader would be essentially delta neutral. If the portfolio delta is 1 or higher, the portfolio is not delta neutral. That means that the professional trader has to make adjustments to the portfolio to bring the delta near zero.

Delta Neutral

When the portfolio is near zero delta, the professional trader does not have to worry about the changes in the market; the portfolio is near delta neutral. With that said, the professional trader can choose a bias to go long or short whenever he believes there is an opportunity for profit. Once the bias is established, the portfolio is exposed to the changes in the market. For instance, when the delta equals 1, that means the options portfolio will change in value equal to the underlying financial instrument. The same applies for when the delta is negative 1 for a bear market bias.

Finally, delta hedging can become more complicated when the trader factors in the gamma risk. This requires gamma hedging, which is the same idea, only it bases the transactions on making the gamma near zero.

Horizontal Spread Strategy

The horizontal spread is one of many options strategies. However, few strategies are able to take advantage of the discrepancies of the time value in options. The horizontal spread strategy, also known as a calendar spread, is best for capturing an obvious discrepancy of an expiration month's average options price.

Here's an example with July and September expiration months. Say the volatility in the market is 20% and the options for July and September are implying a 18% and 22% volatility, respectively. First, knowing that implied volatility should be at or near 20%, the September options are relatively more expensive than July's expiration. However, there is still more time value for September, so that is not a clear signal to write September options and buy July options.

Using the common analytical calculations, theta is examined.  Theta is the price sensitivity of the option per lapsing day. If theta for July strike priced option is much greater than September's option that means that someone could sell July strike priced option and buy September strike priced option for a short term horizontal spread.

The Bull Vertical Spread Strategy

The bull vertical spread strategy is a very popular strategy for casual investors who wish to enjoy tremendous rates of returns. Unlike trading options outright the bull call spread has the advantage of leveraging the position. The initial outlay for a bull call spread can make room for more positions, meaning greater rates of return, overall.

Take for example, options on the S&P 500. If the market is trading near 1200 and we have two different strike priced options at 800 and 1000, we would  buy the 800 call and sell the 1000 call. This gives a below the market bull call spread. This has a definite maximum loss and maximum gain. Since we know the maximum loss is equivalent to the cost of the position we need to know where the market has to reach in order for us to be profitable or not lose our entire investment.

In this case, since it is already in the money so long as the market stays at or above 1000 we will realize our maximum gain, therefore the cost of the position is near the maximum gain, or else we would have a high probability with a high payoff.

Credit Spread Options

The credit spread option is essentially a limited gain, limited risk strategy that seeks to profit by selling options. For call options one would sell the low strike price option and buy the higher strike priced option. Hence, the spread will be net credit.

In other words, at the outset of the position the account will collect premium with the intention of profiting by a sideways market or a bull market, having neither preference. This is a premium collection strategy with limited risk as opposed to selling naked options with unlimited risk.

This options strategy is ideal for people who are invested in markets that have reached a cyclical or seasonal low. This allows the net credit spread to receive richer premiums with balanced risk as opposed to risking more in times of market peaks.

Once the options reach time of delivery (expiration), the premium that was collected at the outset, will be retained but no more profit can be achieved no matter how high the market goes up. Ideally, one should use the strategy with less than six weeks left until expiration, that way the investor can take advantage of the rapid time value decay of the options.

Options Trading 101: The Bear Call Spread

The bear call spread is used to profit from an expected drop in the price of the market. The strategy writes call options as opposed to buying call options for the bull call spread. When writing options, remember there is an advantage to the passage of time. There is a time value to options that goes above and beyond the true option value considered at time of expiration. If this time value is great, then some or all of it can essentially be reaped when writing options, especially in a spread where the risk is determined at time of purchase.

The bear call spread is different from bear put spreads. Where the bear put spread is advantageous to a delayed decline in price the bear call spread can be more advantageous to an imminent decline.

Take for example the S&P 500, let's say it is trading near 1200 and the strike prices for the bear call spread are 1100 and 1200. Which of these will be bought and which one will be written ? The 1100 call will be written and the 1200 call will be bought. That means the profit zone is anywhere between 1100 and 1200, with a maximum profit if the S&P 500 reaches 1100 or lower.

Keep in mind, that in terms of the brokerage account this is considered a credit spread. In other words, another title for the bear call spread is a credit call spread. The example above was essentially an at the money credit call spread. This will receive a net credit which is greater than an above the money spread and is less than a below the money spread.

A net credit is premium which is collected into the account which is marginable. So if the net credit premium for the at the money example is $1,000 once the market stays the same level, goes lower, anything but increase in value the erosion of the premium will turn profit for the account. Let's say with a month left until expiration the net credit is now $500. This means that a new trader who wishes to perform the same credit call spread will be collecting only $500, and if you wish to close the trade your profit will be the $500, essentially the collection of the premium that had eroded.

Now if the credit call spread is done above the money, essentially in this instance above 1200, the amount of premium collected will be less yet there will be a higher probability that the strategy will be profitable. The opposite is true for a below the money spread, which would be below 1200. The amount of premium collected will be greater yet there is a lower probability that the strategy will be successful.

All in all, the best way to use this strategy is to trade an at the money strike price on the write side and leave the trade to expire no more than 6 months.