Delta-Neutral Option Trading

09/27/2011 4:00 pm EST

Focus: OPTIONS

Kerry Given, PhD

Founder and Managing Director, Parkwood Capital LLC

Delta-neutral option strategies allow you to maximize profits while limiting risk, explains Kerry Given, but there are some important considerations and risk factors for traders looking to effectively implement this type of strategy.

I’m talking the Delta-neutral option strategy with Kerry Given. Kerry, what is a Delta-neutral strategy?

When you trade options, you always have risks from three places. One is that price can move against you through the price of the underlying stock or index. Number two is time can be on your side or against you, either way. The third variable that always can hurt you or help you is implied volatility.

When you have an option strategy where price doesn’t have to move very much at all and you’re still good, then that’s a Delta-neutral strategy, where Delta is the Greek that describes our price dependence.

So if it’s Delta neutral, that means that my price can move around a bit and it doesn’t bother me.

See related: Know Your Option “Greeks”

Is that the best strategy then?

No, that’s one of the myths in this business. There is no such thing as the “best” option strategy, but some people have their favorite, and of course, there’s nothing wrong with having your favorite strategy.

Does it work in either a high-volatility environment or low-volatility environment?

It works in both. It depends somewhat on how you’re trading it.

For example, an iron condor is a good example of a Delta-neutral strategy. You could use that in what I would call the “insurance model,” or you can use that in an opportunistic model.

Opportunistically, I might use it when I have a stock that I think is going to trade sideways for the next month, and I might play an iron condor on that stock.

In other cases, I might be playing the iron condor on an index every month and I don’t worry about whether volatility is high or low because I’m putting on the spreads exactly the same way month after month using a standard deviation calculation.

The standard deviation calculation gets larger automatically if volatility is high, so that automatically pushes my spreads farther out of the money and makes it safer.

Is this a good time to be using that strategy?

It’s actually, if you’re using what I call the insurance model, you could use it any month.

In fact, I trade it every month. I don’t worry about whether this is a “good” month or not. I simply trade it and follow my rules with great discipline, and if you manage the risk properly, you’ll do well.

You know, we talk about monthly options when we’re talking this strategy, but there are also weekly options. Will this strategy work with weekly options?

I don’t recommend it with weeklies for this reason: One of the things you have to do with the iron condor is be able to adjust it if the market moves against you.

With weeklies, the market can move against you in a matter of hours. You just don’t have an opportunity to adjust it.

The weekly options, in my mind, are kind of a win/lose trade. You either put it on and it works, or you put it on and you lose. You don’t have any way to manage it in between.

Related Reading:

Related Articles on OPTIONS