A position is delta neutral when the change in the value of one or more securities is exactly offset by a corresponding change in the value of the associated derivatives within the position.
Traders use delta neutral positions either as a hedge in securities trading or as a strategy to profit from alternate sources of derivative value, such as time decay and implied volatility.
Delta neutrality relies on the use of the delta value of options, which is the direct relationship between the price of a security and the price of the associated option. For example, if an option has a delta value of 0.5, then a $10 increase in the price of the security would lead to a $5 increase in the price of the option.
A trader can select an option or set of options whose delta directly offsets any change in value in the underlying security.
Delta Neutral Example
Suppose that a trader is looking to create a delta neutral position with 10 shares of company A that he owns. To do so he decides to purchase 20 options, each with a delta of -0.5.
Therefore, a $1 increase in the price of the shares would lead to a $10 gain (10 shares x $1 gain each) exactly offset by a $10 loss (20 options x -$0.5 loss each), which would be a delta neutral position. Any change in the price of the company A shares is exactly offset by the change in the price of the associated options.
Delta Neutrality and Trading
There are a number of reasons why a trader may wish to establish a delta neutral position. While hedging for a security may have been the most common reason to establish a delta neutral position originally, the growing popularity of options-based trading strategies has led to a vast proliferation of complex and sophisticated strategies based primarily or solely on the value of options as opposed to their associated securities.
For example, one of the most common reasons for establishing a delta neutral position originally was to hedge temporarily. If a trader expects a security’s price to rise in the long run yet fall in the short run, they may select to offset the short term position loss by purchasing put options to create a delta neutral position in the short term.
By contrast, many contemporary delta neutral strategies actually aim to profit from the change in the price of the derivatives in the position, and it is the securities themselves that are purchased to create a delta neutral position. Many delta neutral strategies are primarily options-focused, with the associated securities used to isolate and control for the delta value in the options.
The growth in options-based strategies has led to the relative decline of delta neutral hedging strategies compared to strategies that are designed to profit from an increase in the value options while maintaining a delta neutral position.
A delta neutral position can be employed for a number of reasons, from hedging to options-based strategies aiming to profit from other sources of option value, such as time decay or implied volatility. Delta neutral strategies are another example of the complex and sophisticated positions that can be crafted using an advanced understanding of options and other derivatives.