Home / Blog / HEDGING AND DELTA NEUTRAL STRATEGY

HEDGING AND DELTA NEUTRAL STRATEGY

neutral strategy IMPORTANCE OF DISCIPLE IN TRADING

When we trade, we predict the market movements and we buy or write either a Call option or a Put option. If the market moves as per our calculation, we earn the maximum profit. This is an ideal situation. However, the market is not influenced by one person. So how do we have a safety net that will protect us when the market goes opposite to our expectations?

This is where we HEDGE OUR OPTIONS. So what is hedging?

Hedging is done to safeguard our existing position. In hedging, we take up options of opposite sides, to minimize the risk of loss and still earn a constant income. It may cut down the profit if the profits, but on the contradictory, if saves us from the huge losses that would have been incurred if the market goes the opposite direction.

There are different ways to hedge our position. The most simple and efficient type of hedging strategy is the DELTA NEUTRAL STRATEGY

Delta Neutral strategy is a strategy that utilizes multiple positions with balancing positive & negative delta (options) of the assets. It is placing our options at equal distance from the market’s current price. In this way, if the loss is incurred, it will be bearable and is the minimum loss that could be incurred.

So how do we initiate the trade? We WRITE THE OPTIONS. Most of the traders initiate the trade by BUYING. But in this strategy, we first write (sell) the options. We close the trade by buying.

So we write a call option AGAINST a put option. This helps to lock the profit. The options must be equivi distant from the base price (ie) the market’s current trading price.

The advantage of the equivi- distant price range is that the trader need not be affected by the small market fluctuation. He is protected from the minor market movements. This eventually leads to holding the trade for as many days as possible. This strategy is very ideal for the sideways market.

How to go about the strategy?
The decision on which option should be written (sold) first is the key main factor in this strategy. The call option should be written first, if the market is against the call option and vice versa. The market’s volatility decides what the range, strike price of options that should be selected.

In a low volatile market, the option range selected can be less, since the market would move mildly and not much drastic movement would take place. So, the trade that the trader chooses can be held longer.

In a very high volatile market, the range of the option should be held higher. The volatility would move drastically. If the range is less, then the duration of the trade could be less than a day. So the range selection is the most critical part of the strategy.

For Delta Neutral Strategy, the exit is more important than the entry. This is because we are setting a range for our trade. The entry can be done at any point, even if the market is rapidly changing. But, it is advisable to enter when the market is stable. The exit must however be as per the plan.

We should not let our emotions get hold of us when the range closes. If the trade is not closed when the range is close by, the trader will start to lose his profits, and eventually will incur losses.

So what happens if the pair is closed after the range is close by?
If the trade is closed after the range is crossed, the premium of one option starts to rapidly decrease. This will eventually lead to the reduction of the profit already earned. This is because, the loss incurred will be more than the profit that the other option is earning.

So what happens if the pair is closed before the range is close by?
If the pair is closed before the range closes, the trader loses his potential profits. This is because the trade may continue for days together. Since we are writing the options first, the time decay will earn profits on a daily basis. The more delay the range closes, the time decay earn the profit for the trade. Thus closing the trade early, (ie) before the range closes will cut down the potential profits of the trader.

Thus, we now know the importance of the range and exiting at the correct point of time.

Advantages of Delta Neutral Strategy

1)Time Decay
Since the options are first written of, the time decay is in our favor. The longer we hold the position, the greater time value will be realized. This is the reason the strategy opens a trade by writing an option. If the options are correctly chosen, maximum profit can be earned, no matter how the market goes. This is why many traders try to implement this strategy to their best use.

2)Market Volatility
Since we choose a range within which the options are chosen, the market volatility within the range will not affect our position. Thus the entry and exit of the trade will not be frequent as compared to open calls. The stable market volatility will again help the benefit of the time decay.

3)Hedging
Since the calls and puts are hedged against each other, small market movements will not affect our position. Thus we can travel along the market without fear of small market movements. The hedging should be done at the correct time when keeping in mind the trend the market is functioning.

Disadvantages of Delta Neutral Strategy

Even the most successful trader will have his failure. Even the best strategy has some disadvantages. Only if the trader is aware of these things, he can make the best use of his trade.

HIGH MARKET VOLATILITY

When the market is very volatile, or when the market takes a trend, the market would exceed our range within a day, thus the time value benefit will be lost. At the same time, due to high market trend, the premium value of the options will increase drastically. Thus while closing the trade; we buy the options at a higher rate than when we sold the options. This strategy should be used only when the trade will be in use for at least 1 week. If not, there will not be any advantage of the time value and will only result in loss.

If the trader is not sure of the range that he is about to choose, it is advisable to stay and observe the market, understand the trend and then slowly choose the range and the pair.