Delta Neutral Strategy
This is one of the most important strategies. Here
we'll see how Delta can be used for forming a safe strategy. In each and every
strategy delta is taken into consideration in order to assess the risk. Before
going in depth about the delta neutral strategy some basic assumptions about
the delta are given below:
- Delta of an option (i.e. call/put) increases once the option transit from 'out of money' to 'in the money'.
- 'At the money call option' has delta as +0.50 or +50%.
- 'At the money put option' has delta as -0.50 or -50%.
- 'Deep in the money call option' delta approach to +1.
- 'Deep out of money put option' delta approach to -1.
- 'Deep out of money call option' delta approach to 0.
- 'Deep out of money put option' delta approach to 0.
- Delta of a 'future' is always +1.
Future and option strategy is formed by keeping the
delta value at zero or approximately at zero. For example if we are telling you
to buy Hindalco future at Rs178/- and cover the future by buying two lots of
180 put option at Rs5.25 then see how the delta neutral strategy works out.
In the above example assume the interest rate per
annum is 12%, implied volatility (which is different from the volatility) is
31.30%, quarterly dividend pay out is Zero and ex-dividend is not falling in
the settlement month. Days left to expiry are 11 days. In this case the delta
of the 180 strike put option works out to be -0.55 %. Hence the net delta of
the strategy is working out to be 1 + (-0.55 x 2) = 0.10 which is very near to
the neutral point zero.
In this strategy if the future climbs to Rs 190/-
after two days then the trader makes profit of Rs12/- per script on the future
position and at that time incurs Some loss in the put option premium.
Net profit will be (Rs 12 - 2 x Rs5.25) X lot size.
Since the profit generated by the future contract is more than the premium paid
by the trader in the put option; the net out come will be a profit. If Hindalco
falls to Rs 165/- after two days of initiating the position then in this case
the put option delta approximately -1. And it will be trading at a premium of
Rs 15/- or above. Trader makes approximately Rs10/- profit per script in the
put option and trader's loss in the future long position will be around 13/-
per script.
Net profit will work out to be (2 x (Rs15 - Rs5.25) - (178-165)) X lot
size.
Delta neutral strategy works well in a highly volatile market having greater chance of move in either direction. Demerit of the delta
neutral strategy is that it fails to give positive result in a range bound
market and in a consolidated market. Trader should watch out for the volatility
factor very closely while initiating the delta neutral strategy. If the
implied volatility falls below the theoretical yearly volatility consecutively
for more than 5 trading days then the trader should exit the strategy by
booking the loss.
