Are you having a hard time predicting if the stock prices would go up or down? You applied every bit of technical or fundamental analysis you knew but still the prices go opposite to your prediction. Well, we can definitely help you to overcome this. Delta neutral option strategies can be adapted to profit from the market irrespective of the direction it goes. In these strategies, you play on the volatility of stock and not its price. It really doesn’t matter if the stock price is rising or falling. Interesting, right? Read through to understand more.
What is Delta Neutral?
Delta is a Option Greek which signifies how much the price of Option would change for every 1 unit of change in the price of underlying. For Ex: a Call option with Delta=0.5 would change by 0.5 units for every 1 unit change in price of underlying. Delta value for call options is positive while delta value for Put options is negative. Delta Neutral refers to a strategy where the sum total of Delta for your positions is zero. Such strategy would not get affected by any positive or negative movement in the underlying prices. Delta neutral strategies can be created by Options alone or any combination of Futures and Options. In the next section, we would go through some of the popular Delta neutral option strategies and their payoff graph.
Check out below post to understand and calculate Option greeks.
A Long Straddle is constructed by buying ATM Call and Put options of the same quantity. For Ex: If Nifty is trading at 8410, then buy 8400 CE and 8400 PE. The delta of call option is nullified by the negative delta of put option, thus making this strategy delta neutral. The total premium paid is the sum total of premium of call option and put option. This is a net debit strategy and the breakeven depends on the strike price of the options bought.
Here are some of the characteristic features of long Straddle:
Profit Potential: Unlimited
Maximum Loss: Net Debit Paid (the amount paid for buying Call and Put option)
Breakeven Point: Strike price of Call Option-Net Debit paid or Strike price of Put Option+Net Debit paid
When to execute this strategy: This strategy should be executed when you are anticipating a huge swing in stock price but not sure about the direction. For ex: Earnings announcement, Union budget, Election results etc.
Example: Suppose Nifty is trading at 8410, and you bought 1 lot 8400 CE and 1 lot 8400 PE. You expect a huge move in the price next day and hence hold these positions overnight. Next day if Nifty opens at 8600, your call options would be in huge profit and Put option would be practically worthless. And if Nifty opens at 8200, then your Put option would be in huge profit and Call option would be worthless. Thus, there is no effect of the direction of price movement. However, if price remains at the same level for couple of days, then Call and Put prices would gradually decrease due to the effect of time decay.
Payoff Graph: Below is the payoff graph of this strategy
A Short Straddle is constructed by writing ATM Call and Put options of the same quantity. For Ex: If Nifty is trading at 8410, then sell 8400 CE and 8400 PE. The negative delta of sold call option is nullified by the positive delta of sold put option, thus making this strategy delta neutral. This is a net credit strategy where you receive credit for the options sold. However, there would be some margin blocked from your account when you execute this strategy.
Here are some of the characteristic features of Short Straddle:
Profit Potential: Limited to the net credit received by selling options
Maximum Loss: Unlimited
Breakeven Point: Strike price of Call Option-Net Credit received or Strike price of Put Option+Net Credit received
When to execute this strategy: This strategy should be executed when you are expecting a minimum movement in stock or consolidation phase. For ex: Holiday seasons, Days after earning announcement when volatility decreases sharply etc.
Example: Suppose Nifty is trading at 8410, and you sold 1 lot 8400 CE and 1 lot 8400 PE. You expect minimum movement in prices for the next couple of days and hence hold this position overnight. Next day if Nifty opens at same price 8410, both your Call and Put option would be in profit due to time decay. Even if the it opens slightly higher or lower there is no loss as one position is hedged by the other. However, any major swings in price can cause huge losses.
Payoff Graph: Below is the payoff graph of this strategy
Long and Short Strangle
Long and Short Strangles are another Delta Neutral option strategies very similar to the Straddles. The primary difference between Straddle and Strangle is that, in Strangles you buy/sell OTM options while in Straddles you buy/sell ATM options.
For Long Strangle, buying OTM options considerably reduces the premium paid but it also shifts the breakeven point to a higher value. All other characteristics of Long Strangle is same as Long Straddle. Below is the payoff graph:
While in Short Strangles, the probability of winning trade is heavily increased by shifting the Option strike prices, but the net profit value is decreased due to discounted rates of OTM options. Below is the payoff graph for Short Strangle:
Straddles and Strangles are the most prominent Delta neutral Option Strategies. There are many more Delta neutral trades you can execute using the combination of Options and Futures. There is no guarantee of 100% success rate for any strategy you chose, but definitely it can increase your probability. Let us know if you have any queries on the strategies we discussed. Find some more interesting Options related theories and strategies in the below link: