Delta-Neutral Option Strategies

03/24/2011 4:00 am EST

Focus: OPTIONS

Kerry Given, PhD

Founder and Managing Director, Parkwood Capital LLC

A Delta-neutral option strategy, explains Kerry Given, allows for trades where significant price movement by the underlying stock or index does not hurt the trader. He shares examples, key risk factors, and describes the environment in which this strategy is most useful.

Joining me in the MoneyShow.com video network studio Dr. Kerry Given. Kerry, what are Delta-neutral option strategies?

Well when you put on any option strategy, one of the important things to realize is where your risk is. You basically, on any options trade, you have risk coming at you in three different ways. One is the obvious one: price. Price can change and affect you. Another one is implied volatility, and another is time. The passage of time may help or hinder you. We have mathematical parameters that describe how sensitive our trade is to each of those areas of risk, and the one called "Delta" is the one that tells us how sensitive is our trade to price movement. When we have a Delta-neutral trade, it basically means that we can have a fair amount of price movement without hurting our trade.

When is that strategy appropriate?

Well generally there's two different philosophies of trading Delta neutral. One is I may trade a stock like Apple (AAPL) computer for example. I may trade that stock over several years, and I may be bullish sometimes and may be bearish sometimes and there maybe some times that I actually think it's just going to trade sideways, in which case I would use a Delta-neutral strategy. But there's another type of trader who basically approaches the market like an insurance company. He puts on the Delta-neutral strategy every month and he basically plays that month after month after month.

What are some of the problems associated with this strategy?

The problem is the risk:reward ratio. It's generally pretty high risk compared to the reward. In other words, you're going to get a maximum profit of maybe 10% or 15%, but you have a large loss. Even though it's a low probability of happening, it's possible. So that means your risk management has to be very robust to keep from ever taking that loss.

Okay, describe "robust" risk management for me.

Well, for example, a good risk management system would include under what conditions do I enter the trade?  Under what conditions do I exit, not just a simple stop loss, but I might have adjustments before I exit completely. All of that should be part of your risk management system.

Can you give me an example of this?

Sure, a very common Delta-neutral strategy is the iron condor. You basically put on a call spread up above the price of the index or the stock and you put a put spread on way below the price. As long as the price of the stock or index stays in between, you're fine. But if it starts ranging too high, for example, your calls are under pressure so you might buy an extra call so that as it continues to go up, your extra call was making your money, which compensates for the spread losing money.

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