It is common for stock trading strategies to involve an expectation for knowing which stocks are going to go up and which stocks are going to go down. It's not always that simple, but it is a cornerstone of stock trading strategies to have a prediction for which direction a stock's price will move.
Option trading introduces many strategies that enable traders to profit on the movement of a stock without having to guess the direction it will move. Traders can bet on volatility, which is a measure of how active the stock price is moving in either direction. This allows traders to take advantage of high-leverage events, where a stock is poised for a big move, even without knowing the exact outcome of the event -- whether it be positive news for the company or negative.
By using delta neutral trading strategies, traders are able to profit off of that volatility -- or lack thereof.
Delta is a measure of how much the price of an option changes as the price of the underlying stock changes. It is given as a value between 0 and 1.0 for call options and 0 and -1.0 for put options.
Delta is positive for call options because the price of a call will rise as the price of the underlying stock rises, and it will drop as the price of the underlying stock drops. Put options have an inverse effect -- when the stock price goes up, the option price goes down, and vice versa.
The actual delta figure indicates the amount the option price will move as the price of the underlying asset moves, per dollar. If the call delta is 0.45, and the underlying stock climbs $1.00, then the price of the call option will rise by $0.45.
To establish a delta neutral position, a trader would buy or sell options and then immediately buy or sell shares of the stock to neutralize the accumulated delta of the option trade. Each share of stock that a trader buys represents +1.0 delta in this strategy. We'll take a look at an example later, but below is a table explaining the basic relationship between buying or selling options with the underlying stock.
|Delta Neutral Trading|
Ultimately, with the right combination of options and stock, the net delta will be 0, and the trader will be protected against the risk of the stock price moving up or down.
There are a number of scenarios where it might be beneficial for a trader to put on a delta neutral position.
One of the most common in the option trading industry is centered around company earnings releases. Quarterly earnings tend to be important events for options because they have the possibility to stimulate large positive or negative moves in the stock price. If a company outperforms expected quarterly figures, it can have a significant effect on the price; likewise, if they fall short of expectations, stock prices can drop quickly. If a trader can anticipate market conditions which allow for the possibility of one of these moves, without knowing in which direction the move might occur, establishing a delta neutral position can be a way to profit off of the large swing without making a bet on a direction.
Similarly, drug development companies present opportunities for volatility. These firms invest a large amount of money in research and development, and all potential drugs must go through a rigorous clinical trial process before being considered for approval by the FDA. At various points throughout the process, the company will release updates on the status of the trials. In some cases, the future of the drug -- or the whole company -- may be at stake on the results of this process, so these announcements can create large binary events within the stock's price. Without knowing whether the process will be successful for the company, it is possible to profit by trading against the market's expectations for future volatility, whether a trader believes the market is pricing in too much volatility or too little.
There are many other catalysts that can create these opportunities, including lawsuits, regulatory investigations, and product launches.
In addition to large binary events within the market, it's possible to profit off of the volatility that can occur by erratic or oscillatory price movements in the stock. Many times, a stock can experience high intra-day or day-to-day fluctuations without drifting too far from the original price. These types of movements can also lead to high volatility, so a trader might be willing to make a bet that the market's implied volatility is not enough to match the future movements of the stock.
This can be achieved by establishing a position in an option and then hedging the delta throughout the life of the option. As time goes on and the price in an underlying stock changes, the delta of an option will change too. If a trader buys 1 contract for 100 shares of an at-the-money call option, with a delta of 0.5, initially they will have to sell 50 shares of the stock to net the delta. However, the delta for that option could change over the course of a day or several days, requiring them to buy or sell more shares of the stock in order to neutralize that delta.
Holding the options enables the trader to reduce exposure to risk while trading shares of the stock as it moves up and down. The more it moves up and down, the more the trader stands to profit, returning more than the initial cost required to buy the options. Take a look at the example below. In this case, we have the IBM 18-Nov-16 160.00 strike call options. At the time of the trade, it was the at-the-money strike, and the delta for the call option was 0.5. Over the course of the next several days, the value in the options actually decreases, but the trader is able to profit off of the movement in the underlying stock.
|Buying IBM 18-Nov-16 160 Strike Call Option|
|Net Delta||Stock Price||Shares Bought
to Hedge Delta
to Hedge Delta