THE OPTIONS COURSE- Demystifying Delta
THE OPTIONS COURSE
Delta neutral trading is the key to my success as an options trader. Learning how to trade delta neutral provides traders with the ability to make a profit regardless of market direction while maximizing trading profits and minimizing potential risk. Options traders who know how to wield the power of delta neutral trading increase their chances of success by leveling the playing field. In general, it is extremely hard to make any money competing with floor traders. Keep in mind that delta neutral trading has been used on stock exchange floors for many years.
In fact, some of the most successful trading firms ever built use this type of trading. Back when I ran a floor trading operation, I decided to apply my Harvard Business School skills to aggressively study floor trader methods. I was surprised to realize that floor traders think in 10-second intervals. I soon recognized that we could take this trading method off the floor and change the time frame to make it successful for off-floor traders. Floor traders pay large sums of money for the privilege of moving faster and paying less per trade than off-floor traders.
However, changing the time frame enabled me to compete with those with less knowledge. After all, 99 percent of the traders out there have very little concept of limiting risk, including money managers in charge of billions of dollars. They just happen to have control of a great deal of money so they can keep playing the game for a long time. For example, a friend once lost $10 million he was managing. Ten minutes later I asked him, “How do you feel about losing all that money?” He casually replied, “Well, it’s not my money.” That’s a pretty sad story; but it’s the truth. This kind of mentality is a major reason why it’s important to manage your accounts using a limited risk trading approach.
Delta neutral trading strategies combine stocks (or futures) with options, or options with options in such a way that the sum of all the deltas in the trade equals zero. Thus, to understand delta neutral trading, we need to look at “delta,” which is, in mathematical terms, the rate of change of the price of the option with respect to a change in price of the underlying stock. An overall position delta of zero, when managed properly, can enable a trade to make money within a certain range of prices regardless of market direction. Before placing a trade, the upside and downside breakevens should be calculated to gauge the trade’s profit range.
A trader should also calculate the maximum potential profit and loss to assess the viability of the trade. As the price of the underlying instrument changes, the overall position delta of the trade moves away from zero. In some cases, additional profits can be made by adjusting the trade back to zero (or delta neutral) through buying or selling more options, stock shares, or futures contracts. If you are trading with your own hard-earned cash, limiting your risk is an essential element of your trading approach. That’s exactly what delta neutral trading strategies do. They use the same guidelines as floor trading but apply them in time frames that give off-floor traders a competitive edge in the markets.
Luckily, these strategies don’t exactly use rocket science mathematics. The calculations are relatively simple. You’re simply trying to create a trade that has an overall delta position as close to zero as possible. I can look at a newspaper and make delta neutral trades all day long. I don’t have to wait for the S&Ps to hit a certain number, or confuse myself by studying too much fundamental analysis. However, I do have to look for the right combination of factors to create an optimal trade. An optimal trade uses your available investment capital efficiently to produce substantial returns in a relatively short period of time.
Optimal trades may combine futures with options, stocks with options, or options with options to create a strategy matrix. This matrix combines trading strategies to capitalize on a market going up, down, or sideways. To locate profitable trades, you need to understand how and when to apply the right options strategy. This doesn’t mean that you have to read the most technically advanced books on options trading. You don’t need to be a genius to be a successful trader; you simply need to learn how to make consistent profits. One of the best ways to accomplish this task is to pick one market and/or one trading technique and trade it over and over again until you get really good at it.
If you can find just one strategy that works, you can make money over and over again until it’s so boring you just have to move on to another one. After a few years of building up your trading experience, you will be in a position where you are constantly redefining your strategy matrix and markets. Finding moneymaking delta neutral opportunities is not like seeking the holy grail. Opportunities exist each and every day. It’s simply a matter of knowing what to look for. Specifically, you need to find a market that has two basic characteristics—volatility and high liquidity—and use the appropriate time frame for the trade.
To become a delta neutral trader, it is essential to have a working understanding of the Greek term delta and how it applies to options trading. Almost all of my favorite option strategies use the calculation of the delta to help devise managed risk trades. The delta can be defined as the change in the option premium relative to the price movement in the underlying instrument. This is, in essence, the first derivative of the price function, for those of you who have studied calculus. Deltas range from minus 1 through zero to plus 1 for every share of stock represented. Thus, because an option contract is based on 100 shares of stock, deltas are said to be “100” for the underlying stock, and will range from “–100” to “+100” for the associated options.
A rough measurement of an option’s delta can be calculated by dividing the change in the premium by the change in the price of the underlying asset. For example, if the change in the premium is 30 and the change in the futures price is 100, you would have a delta of .30 (although to keep it simple, traders tend to ignore the decimal point and refer to it as + or – 30 deltas). Now, if your futures contract advances $10, a call option with a delta of 30 would increase only $3. Similarly, a call option with a delta of 10 would increase in value approximately $1. One contract of futures or 100 shares of stock has a fixed delta of 100. Hence, buying 100 shares of stock equals +100 and selling 100 shares of stock equals –100 deltas.
In contrast, all options have adjustable deltas. Bullish option strategies have positive deltas; bearish option strategies have negative deltas. Bullish strategies include long futures or stocks, long calls, or short puts. These positions all have positive deltas. Bearish strategies include short futures or stocks, short calls, or long puts; these have negative deltas. As a rule of thumb, the deeper in-the-money your option is, the higher the delta. Remember, you are comparing the change of the futures or stock price to the premium of the option. In-the-money options have higher deltas. A deep ITM option might have a delta of 80 or greater. ATM options—these are the ones you will be probably working with the most in the beginning—have deltas of approximately 50.
OTM options’ deltas might be as small as 20 or less. Again, depending how deep in-the-money or out-of-the-money your options are, these values will change. Think of it another way: Delta is equal to the probability of an option being in-the-money at expiration. An option with a delta of 10 has only a 10 percent probability of being ITM at expiration. That option is probably also deep OTM. When an option is very deep in-the-money, it will start acting very much like a futures contract or a stock as the delta gets closer to plus or minus 100. The time value shrinks out of the option and it moves almost in tandem with the futures contract or stock.
Many of you might have bought options and seen huge moves in the underlying asset’s price but hardly any movement in your option. When you see the huge move, you probably think, “Yeah, this is going to be really good.” However, if you bought the option with a delta of approximately 20, even though the futures or stock had a big move, your option is moving at only 20 percent of the rate of the futures in the beginning. This is one of the many reasons that knowing an option’s delta can help you to identify profitable opportunities. In addition, there are a number of excellent computer programs geared to assist traders to determine option deltas, including the Platinum.
Obviously, you want to cover the cost of your premium. However, if you are really bullish on something, then there are times you need to step up to the plate and go for it. Even if you are just moderately friendly to the market, you still want to use deltas to determine your best trading opportunity. Now, perhaps you would have said, “I am going to go for something a little further out-of-the-money so that I can purchase more options.” Unless the market makes a big move, chances are that these OTM options will expire worthless. No matter what circumstances you encounter, determining the deltas and how they are going to act in different scenarios will foster profitable decision making.
When I first got into trading, I would pick market direction and then buy options based on this expected direction. Many times, they wouldn’t go anywhere. I couldn’t understand how the markets were taking off but my options were ticking up so slowly they eventually expired worthless. At that time, I had no knowledge of deltas. To avoid this scenario, remember that knowing an option’s delta is essential to successful delta neutral trading. In general, an option’s delta:
• Estimates the change in the option’s price relative to the underlying security. For example, an option with a delta of 50 will cost less than an option with a delta of 80.
• Determines the number of options needed to equal one futures contract or 100 shares of stock to ultimately create a delta neutral trade with an overall position delta of zero. For example, two ATM call options have a total of +100 deltas; you can get to zero by selling 100 shares of stock or one futures contract (–100 deltas).
• Determines the probability that an option will expire in-the-money. An option with 50 deltas has a 50 percent chance of expiring in-the-money.
• Assists you in risk analysis. For example, when buying an option you know your only risk is the premium paid for the option.
To review the delta neutral basics: The delta is the term used by traders to measure the price change of an option relative to a change in price of the underlying security. In other words, the underlying security will make its move either to the upside or to the downside. A tick is the minimum price movement of a particular market. With each tick change, a relative change in the option delta occurs. Therefore, if the delta is tied to the change in price of the underlying security, then the underlying security is said to have a value of 1 delta. However, I prefer to use a value of 100 deltas instead because with an option based on 100 shares of stock it’s easier to work with.
Let’s create an example using IBM options, with IBM currently trading at $87.50.
• Long 100 shares of IBM = +100 deltas.
• Short 100 shares of IBM = –100 deltas.
Simple math shows us that going long 200 shares equals +200 deltas, going long 300 shares equals +300 deltas, going short 10 futures contracts equals –1,000 deltas, and so on. On the other hand, the typical option has a delta of less than 100 unless the option is so deep in-the-money that it acts exactly like a futures contract. I rarely deal with options that are deep in-the-money as they generally cost too much and are illiquid.
All options have a delta relative to the 100 deltas of the underlying security. Since 100 shares of stock are equal to 100 deltas, all options must have delta values of less than 100. An Option Delta Values chart can be found in Appendix B outlining the approximate delta values of ATM, ITM, and OTM options.
Volatility measures market movement or nonmovement. It is defined as the magnitude by which an underlying asset is expected to fluctuate in a given period of time. As previously discussed, it is a major contributor to the price (premium) of an option; usually, the higher an asset’s volatility, the higher the price of its options. This is because a more volatile asset offers larger swings upward or downward in price in shorter time spans than less volatile assets. These movements are attractive to options traders who are always looking for big directional swings to make their contracts profitable. High or low volatility gives traders a signal as to the type of strategy that can best be implemented to optimize profits in a specific market.
I like looking for wild markets. I like the stuff that moves, the stuff that scares everybody. Basically, I look for volatility. When a market is volatile, everyone in the market is confused. No one really knows what’s going on or what’s going to happen next. Everyone has a different opinion. That’s when the market is ripe for delta neutral strategies to reap major rewards. The more markets move, the more profits can potentially be made. Volatility in the markets certainly doesn’t keep me up at night. For the most part, I go to bed and sleep very well. Perhaps the only problem I have as a 24-hour trader is waking up in the middle of the night to sneak a peek at my computer.
If I discover I’m making lots of money, I may stay up the rest of the night to watch my trade. As uncertainty in the marketplace increases, the price for options usually increases as well. Recently, we have seen that these moves can be quite dramatic. Reviewing the concept of volatility and its effect on option prices is an important lesson for beginning and novice traders alike. Basically, an option can be thought of as an insurance policy—when the likelihood of the “insured” event increases, the cost or premium of the policy goes up and the writers of the policies need to be compensated for the higher risk.
For example, earthquake insurance is higher in California than in Illinois. So when uncertainty in an underlying asset increases (as we have seen recently in the stock market), the demand for options increases as well. This increase in demand is reflected in higher premiums. When we discuss volatility, we must be clear as to what we’re talking about. If a trader derives a theoretical value for an option using a pricing model such as Black-Scholes, a critical input is the assumption of how volatile the underlying asset will be over the life of the option. This volatility assumption may be based on historical data or other factors or analyses.
Floor and theoretical traders spend a lot of money to make sure the volatility input used in their price models is as accurate as possible. The validity of the option prices generated is very much determined by this theoretical volatility assumption. Whereas theoretical volatility is the input used in calculating option prices, implied volatility is the actual measured volatility trading in the market. This is the price level at which options may be bought or sold. Implied volatilities can be acquired in several ways. One way would be to go to a pricing model and plug in current option prices and solve for volatility, as most professional traders do.
Another way would be to simply go look it up in a published source, such as the Optionetics Platinum site. Once you understand how volatilities are behaving and what your assumptions might be, you can begin to formulate trading strategies to capitalize on the market environment. However, you must be aware of the characteristics of how volatility affects various options. Changes in volatility affect at-the-money option prices the most because ATM options have the greatest amount of extrinsic value or time premium—the portion of the option price most affected by volatility.
Another way to think of it is that at-the-money options represent the most uncertainty as to whether the option will finish in-the-money or out-of-the-money. Additional volatility in the marketplace just adds to that. Generally changes in volatility are more pronounced in the front months than in the distant months. This is probably due to greater liquidity and open interest in the front months. However, since the back month options have more time value than front month options, a smaller volatility change in the back month might produce a greater change in option price compared to the front month. For example, assume the following (August is the front month):
• August 50 calls (at-the-money) = $3.00; Volatility = 40%
• November 50 calls (at-the-money) = $5.00; Volatility = 30%
Following an event that causes volatility to increase we might see:
• August 50 calls = $4.00; Volatility = 50%
• November 50 calls = $6.50; Volatility = 38%
We can see that even though the volatility increased more in August, the November options actually had a greater price increase. This is due to the greater amount of time premium or extrinsic value in the November options. Care must be taken when formulating trading strategies to be aware of these relationships. For example, it is conceivable that a spread could capture the volatility move correctly, but still lose money on the price changes for the options. Changes in volatility may also affect the skew: the price relationship between options in any given month. This means that if volatility goes up in the market, different strikes in any given month may react differently. For example, out-of-the-money puts may get bid to a much higher relative volatility than at-the-money puts.
This is because money managers and investors prefer to buy the less costly option as disaster protection. A $2 put is still cheaper than a $5 put even though the volatility might be significantly higher. So how does a trader best utilize volatility effects in his/her trading? First, it is important to know how a stock trades. Events such as earnings and news events may affect even similar stocks in different ways. This knowledge can then be used to determine how the options might behave during certain times. Looking at volatility graphs is a good way to get a feel for where the volatility normally trades and the high and low ends of the range. A sound strategy and calculated methodology are critical to an option trader’s success.
Why is the trade being implemented? Are volatilities low and do they look like they could rally? Remember that implied volatility is the market’s perception of the future variance of the underlying asset. Low volatility could mean a very flat market for the foreseeable future. If a pricing model is being used to generate theoretical values, do the market volatilities look too high or low? If so, be sure all the inputs are correct. The market represents the collective intelligence of the option players’ universe. Be careful betting against smart money. Watch the order flow if possible to see who is buying and selling against the market makers. Check open interest to get some indication of the potential action, especially if the market moves significantly. By keeping these things in mind and managing risk closely, you will increase your odds of trading success dramatically.
RELATIONSHIP BETWEEN VOLATILITY AND DELTA
One of the concepts that seems to confuse new options traders is the relationship between volatility and delta. First, let’s quickly review each topic separately. Volatility represents the level of uncertainty in the market and the degree to which the prices of the underlying are expected to change over time. When there is more uncertainty or fear, people will pay more for options as a risk control instrument. So when the markets churn, investors get fearful and bid up the prices of options. As people feel more secure in the future, they will sell their options, causing the implied volatility to drop. Delta can be thought of as the sensitivity of an option to movement in the underlying asset.
For example, an option with a delta of 50 means that for every $1 move in the underlying stock the option will move $0.50. Options that are more in-the-money have higher deltas, as they tend to move in a closer magnitude with the stock. Delta can also be thought of as the probability of an option finishing in-the-money at expiration. An option with a delta of 25 has a 25 percent chance of finishing in-the-money at expiration. An increase in volatility causes all option deltas to move toward 50. So for in-the-money options, the delta will decrease; and for out-of-the-money options, the delta will increase.
This makes intuitive sense, for when uncertainty increases it becomes less clear where the underlying might end up at expiration. Since delta can also be defined as the probability of an option finishing in-the-money at expiration, as uncertainty increases, all probabilities or deltas should move toward 50–50. For example, an in-the-money call with a delta of 80 under normal volatility conditions might drop to 65 under a higher-volatility environment, reflecting less certainty that the call will finish in-the-money. Thus, by expiration, volatility is zero since we certainly know where the underlying will finish.
At zero volatility, all deltas are either 0 or 1, finishing either out-of-the-money or in-the-money. Any increase in volatility causes probabilities to move away from 0 and 1, reflecting a higher level of uncertainty. It is always important to track volatility, not only for at-the-money options but also for the wings (out-of-the-money) options as well. A trade may have a particular set of characteristics at one volatility level but a completely different set at another. A position may look long during a rally but once volatility is reset, it may be flat or even short. Knowing how deltas behave due to changes in volatility and movement in the underlying is essential for profitable options trading.
APPROPRIATE TIME FRAME
The next step is to select the appropriate time frame for the kind of trade you want to place. Since I am no longer a day trader, I’m usually in the 30-to 90-day range of trading. And for the most part, I prefer 90 days. Since I don’t want to sit in front of a computer all day long at this point in my trading career, I prefer to use delta neutral strategies. They allow me to create trades with any kind of time frame I choose. Delta neutral strategies are simply not suitable for day trading. In fact, day trading doesn’t work in the long run unless you have the time and the inclination to sit in front of a computer all day long.
Day trading takes a specific kind of trader with a certain kind of personality to make it work. My trading strategies are geared for a longer-term approach. If you’re going to go into any business, you have to size up the competition. In my style of longer-term trading, my competition is the floor trader who makes money on a tick-by-tick basis. But I choose not to play that game. I’ve taken the time frame of a floor trader—which is tick-by-tick—and expanded it to a period floor traders usually don’t monitor. Applying my strategies in longer time frames than day-to-day trading is my way of creating a trader’s competitive edge.
Delta neutral trading combines options with stocks (or futures) and options with options to create trades with an overall position delta of zero. To set up a balanced delta neutral trade, it is essential to become familiar with the delta values of ATM, ITM, and OTM options. Deltas provide a scientific formula for setting up trading strategies that give you a competitive edge over directional traders. Experience will teach you how to use this approach to take advantage of various market opportunities while managing the overall risk of the trade efficiently. I cannot stress enough the importance of developing a working knowledge of the deltas of options.
Professional options traders think in terms of spreads and they hedge themselves to stay neutral on market direction. The direction of the underlying stock is less important to them than the volatility of the options (implied volatility) and the volatility of the underlying stock (statistical or historical volatility). Professional options traders also let the market tell them what to do. They recognize the market is saying that the appropriate strategy is to sell premium when option volatility is high (options are expensive).
Conversely, they understand the market is saying that the low-risk strategy is to buy premium when implied volatility is low (options are cheap). The most difficult aspect of delta neutral options trading is learning to stay focused on volatility. The reason it’s psychologically hard to trade on volatility considerations is because it’s natural to look at a price chart, draw conclusions about future market direction, and be tempted to bias your positions in the direction you feel prices will move.
However, the point of delta neutral trading is that you want to make money based on how accurately you forecast volatility; you don’t want to run the risk of losing money by forecasting market direction incorrectly. That’s why you should initiate your spreads delta neutral. It’s also why you should adjust them back to neutral if they later become too long or short— which brings us to the second most difficult aspect of delta neutral options trading: acting without hesitation when the market tells you to act. If your position becomes too long or short, you must mechanically adjust it without hoping for the price to move in the direction of your delta bias.
While it’s natural to want to give the market a chance to go your way, the fact of the matter is that the market has already proven you wrong, so it would only be wishful thinking to expect it will suddenly move the way you want. Every delta neutral trader knows the feeling of having a weight lifted from his shoulders the moment he or she does the right thing by executing an adjustment to get neutral. When you buy premium, be prepared to take action if the market makes a big move so you can lock in profits.
When you sell premium, don’t expect volatility to collapse right away. You will probably need to be patient. You hope the underlying asset won’t move a lot while you’re waiting. However, time decay helps you while you’re waiting. As you can see, the concept of delta neutral is not one trade, but rather a method of advanced thinking. If you can master the basics of delta neutral thinking, then you can create delta neutral trades from any combination of assets. The concept is to be able to make a profit regardless of where the stock moves.