What is Delta Neutral?
Delta neutral is a portfolio strategy using several positions, balancing positive and negative deltas so that the overall delta of the assets in question is zero.
Delta Neutral explained
A neutral delta portfolio equalizes the response to market movements for a certain range in order to bring the net change in position to zero. Delta measures the change in the price of an option when the price of the underlying security changes.
As the value of the underlying assets changes, the position of the Greeks shifts between positive, negative and neutral. Investors who wish to maintain delta neutrality must adjust their portfolios accordingly. Option traders use delta neutral strategies to take advantage of either the implied volatility or the temporal decrease in options. Delta neutral strategies are also used for hedging purposes.
Delta Neutral Basic Mechanics
Long put options always have a delta ranging from -1 to 0, while long calls always have a delta ranging from 0 to 1. The underlying asset, generally a stock position, always has a delta of 1 if the position is a long position and -1 if the position is a short position. Given the underlying asset position, a trader or investor can use a combination of long and short calls and sales to achieve the effective delta 0 of a portfolio.
If an option has a delta of one and the underlying position increases by $ 1, the price of the option will also increase by $ 1. This behavior is observed with deep currency options. Likewise, if an option has a delta of zero and the stock increases by $ 1, the price of the option will not increase at all (behavior seen with deep out-of-the-money call options). If an option has a delta of 0.5, its price will increase by $ 0.50 for each $ 1 increase in the underlying stock.
An example of Delta neutral coverage
Suppose you have a stock position that you think will increase over the long term. However, you are concerned that prices will fall in the short term, so you decide to set up a delta neutral position. Suppose you own 200 shares of Company X, which trades at $ 100 per share. Since the delta of the underlying action is 1, your current position has a positive delta of 200 (the delta multiplied by the number of actions).
To get a neutral delta position, you must enter a position that has a total delta of -200. Suppose you find money options on company X that trade with a delta of -0.5. You can buy 4 of these put options, which would have a total delta of (400 x -0.5) or -200. With this combined position of 200 shares of company X and 4 long put options on a par with company X, your overall position is neutral in terms of delta.