Who would want to eliminate direction from trading? One answer is premium sellers, as the directional risk can be high. How do traders make money without picking a direction? They rely upon a decrease in implied volatility (IV) and theta (time decay). They can also hedge an option's directional risk using shares of stock (delta).
Delta is the option Greek that indicates how an option’s price will change when the underlying price changes. It impacts the price of an option more than the others (gamma, theta, rho and vega). It is considered the most important Greek to traders. One share of stock always has a delta of 1 because a $1 change in the stock price results in a P/L of ±$1. Delta represents share equivalency. That is why it’s frequently called a hedge ratio. Stock can be used to hedge options.
Removing delta from the equation leaves volatility and time decay to work for us. We still have to be cognizant of Gamma since it changes delta. An example of a delta neutral position in AAPL was used to demonstrate the points made.
For more on Delta see:
- Options Jive from February 16, 2016: “Option Risks | Direction (Delta)”.
For more on how Gamma impacts a Delta hedged position see:
- Options Jive from April 18, 2016: “Delta After Market Moves | Compensating for Gamma”.
Watch this segment of “Best Practices” with Tom Sosnoff and Tony Battista for a better understanding of how to use Delta as a hedging tool and to take direction out of the profit/loss equation.
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