Best Practices

Delta Neutrality

| Dec 22, 2014
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    Best Practices

    Delta Neutrality

    Dec 22, 2014

    There are many approaches one can take while trading. One method many traders use is known as delta neutrality. So, what is delta neutrality? Since delta represents a position’s directional risk, delta neutrality refers to a position that is directionally neutral, or doesn’t make or lose any money with small movements in the underlying.

    Why would someone want to trade a delta-neutral position or portfolio? There are certain strategies that can profit without picking any direction, such as a short straddle or short strangle. These types of trades rely on the passage of time and changes in volatility to profit as opposed to a directional move. Other uses of employing delta-neutrality are to mitigate directional risk, and to lock in profits or losses.

    Before creating a delta-neutral position or portfolio, we have to understand that each delta represents the amount your position or portfolio will gain or lose with changes in the underlying. For example, if you have a position on in AAPL that has a delta value of -80, that position will lose $80 for every 1-point increase in AAPL. Since one share of stock has one delta, we would need to buy 80 shares of stock to create a delta-neutral AAPL position.

    On a portfolio level, we first have to convert each position’s individual delta to the same unit. To do this, we beta-weight our portfolio deltas to SPY, which adjusts each of our position’s to reflect their directional exposure to movements in SPY. After beta-weighting, we can use shares of SPY to hedge our entire portfolio. For example, if after beta-weighting to SPY we find our portfolio has an overall delta of 125, we could short 125 shares of SPY to achieve delta neutrality. This would protect us from any losses due to small movements in SPY.

    When it comes to futures, all futures have a different delta value per contract. /ES has a delta of 50 per contract, and /NQ has a delta value of 20 per contract. For example, to hedge positions in /ES and /NQ, we would have to keep in mind each contract’s respective delta value to achieve delta-neutrality.

    This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.

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