A delta neutral trade is one in which a long and short option offset one another with net value or cost at or near zero, writes Michael Thomsett of ThomsettOptions.com.
The theme of delta neutrality can refer to many differently constructed strategies including spreads (covered and uncovered) and straddles. When an option position is covered with long stock (including one short option contract offsetting 100 shares of stock), the delta neutral creates an equivalent stock position. This position moves up or down and tracks the 100 shares synthetically, a very effective form of no-cost leverage.
The delta neutral accompanying long stock in theory wipes out risk on both sides of the option trade (the long has no market risk because it is paid for by the short; and the short has no market risk because it is covered). However, as volatility changes, so will the relative risks of each option. However, if the risk does offset at the point of entry, traders have a great advantage in being able to react to movement in either direction (or both). The risk applies at the time of entry and subsequent movement can lead to rolling, closing, and expiration.
One variety of this concept involves two short options, one call and one put. The theory behind this is that offsetting exercise risk cancels out in the same way as a covered long and short position. But this is not accurate. Exercise risk exists separately for both sides in a trade of a short call and a short put. It is not neutral. Exercise of either can wipe out the initial credit received and exceed that credit by many points. Making matters worse, both shorts can be exercised when the stock moves in both directions. For example, a short call is ITM on ex-dividend date and is exercised; and then after ex-dividend, the stock price falls and by expiration, the short put is also exercised. The risk is especially severe when the two-short position is a straddle. One or the other of these options will always be ITM. In comparison, a spread may involve two sides, each OTM.
It makes more sense to involve delta neutral trading in positions such as the synthetic short stock—100 shares of long stock, one long put, and one short call. The short call pays the cost of the long put, and the short call is covered. What is the rationale for this position? This is a synthetic short stock strategy, meaning that if the stock price rises, the call grows in value and could be exercised. Because you own 100 shares, this outcome is covered. If the underlying falls, the long put will increase in value. Any loss in the stock is offset point for point in intrinsic value of the put. The put can be closed to take a profit offsetting stock losses, or exercised so the stock can be sold at the strike.
This strategy makes sense if you are concerned about downside risk but want to hold onto the stock. For a stock paying an annual dividend above 4%, for example, this is not bad considering market rates these days. For that reason, setting up a delta neutral position through a synthetic short stock strategy makes a lot of sense. If you are intent on holding onto the stock because of the high dividend, writing a series of synthetics makes sense—it protects against downside decline while keeping ownership of stock. If the short call went ITM, it could be closed or rolled forward.
By Michael Thomsett of ThomsettOptions.com
