Delta Neutral
To be truly direction neutral or direction indifferent means to have a delta
equal to zero. In other words, there are no immediate gains if the underlying
moves incrementally higher or lower. This zero-delta method of trading is
called delta-neutral trading .
A delta-neutral position can be created from any option position simply
by trading stock to flatten out the delta. A very basic example of a delta-
neutral trade is a long at-the-money (ATM) call with short stock.
Consider a trade in which we buy 20 ATM calls that have a 50 delta and
sell stock on a delta-neutral ratio.
Buy 20 50-delta calls (long 1,000 deltas)
Short 1,000 shares (short 1,000 deltas)
In this position, we are long 1,000 deltas from the calls (20 × 50) and
short 1,000 deltas from the short sale of stock. The net delta of the position
is zero. Therefore, the immediate directional exposure has been eliminated
from the trade. But intuitively, there are other opportunities for profit or loss
with this trade.
The addition of short stock to the calls will affect only the delta, not the
other greeks. The long calls have positive gamma, negative theta, and
positive vega. Exhibit 12.1 is a simplified representation of the greeks for
this trade.
EXHIBIT 12.1 20-lot delta-neutral long call.
With delta not an immediate concern, the focus here is on gamma, theta,
and vega. The +1.15 vega indicates that each one-point change in IV makes
or loses $115 for this trade. Yet there is more to the volatility story. Each
day that passes costs the trader $50 in time decay. Holding the position for