When Delta Neutral Isn’t Direction
Indifferent
Many dynamic-volatility option positions, such as the risk reversal, have
vega risk from potential IV changes resulting from the stock’s moving. This
is indirectly a directional risk. While having a delta-neutral position hedges
against the rather straightforward directional risk of the position delta, this
hidden risk of stock movement is left unhedged. In some circumstances, a
delta-lean can help abate some of the vega risk of stock-price movement.
Say an option position has fairly flat greeks at the current stock price. Say
that given the way this particular position is set up, if the stock rises, the
position is still fairly flat, but if the stock falls, short lower-strike options
will lead to negative gamma and vega. One way to partially hedge this
position is to lean short deltas—that is, instead of maintaining a totally flat
delta, have a slightly short delta. That way, if the stock falls, the trade
profits some on the short stock to partially offset some of the anticipated
vega losses. The trade-off of this hedge is that if the stock rises, the trade
loses on the short delta.
Delta leans are more of an art than a science and should be used as a
hedge only by experienced vol traders. They should be one part of a well-
orchestrated plan to trade the delta, gamma, theta, and vega of a position.
And, to be sure, a delta lean should be entered into a model for simulation
purposes before executing the trade to study the up-and-down risk of the
position. If the lean reduces the overall risk of the position, it should be
implemented. But if it creates a situation where there is an anticipated loss
if the stock moves in either direction and there is little hope of profiting
from the other greeks, the lean is not the answer—closing the position is.