What Is Delta Neutral Trading in Options?

There are two kinds of trading strategies. The first kind of trading is directional strategies and the second one is non-directional strategies. In directional strategies the traders are looking to predict the direction and take the entry. This is usually done by trading the breakouts. A lot of reversal trading is also part of directional strategies. When a trader goes for a reversal trade when the stock hits a resistance or a support, that is also a directional strategy. Essentially in a directional strategy that trader is betting on the direction and hence he takes single direction trade. In case of stocks for futures this will be a direct buy or sell trade. In case of options the trader might go for naked call buying or put buying. The trader can also go for spreads if he wants to have risk defined system. 

The second kind of trading which is even more popular is using nondirectional strategies. In non directional strategies the trader is not predicting any direction and hence goes for Delta neutral strategies. Some of the delta neutral strategy examples are straddles, strangles, iron condors, etc. Traders like this kind of strategy because they do not have to predict the direction which is probably the hardest thing in the market

But in reality, most non-directional trades are not truly neutral when they are initiated. They still carry delta exposure, which means the position can start behaving like a directional trade if the market moves. This is where delta neutral trading becomes important. It is very important for traders to keep balancing that overall strategy so that they can not only benefit from theta and also they should not be penalised for Delta movement. Hence, it is important to understand this concept of delta hedging and balancing to get consistency in non-directional option trading.

What Is Delta?

Delta measures how much the option price changes when the underlying price changes by one point. 

For example, For example if the ATM Call options delta is 0.5 and and the trader expects that Nifty will move by 100 points, then this ATM option is expected to move by 50 points. Hence the calculation is following:

Expected movement in option = Delta * underlying movement

In other words, we can also say that Delta represents the direction exposure. If the overall Delta is high the option or the entire strategy will move faster in that particular direction. It will have a stronger directional sensitivity.

ITM options have high delta and hence move almost in sync with the underlying where OTM options have low delta and hence the movement is slow. Here is the different values for different strikes:

What Does Delta Neutral Mean?

Delta neutral means that the total strategy has a net exposure of zero. For example if one position has a delta of +0.4 (that means we have bought an OTM call option) and another position has a delta of -0.04 (that means we have bought an OTM put option), then the net delta of the entire position is 0. This implies that small movements in the underlying price should have minimal impact on overall P&L. The position becomes less sensitive to small price changes. Once this happens all the trader has to focus on a theta decay, volatility changes and the probability that the market remains range-bound.

The above example that we took its slightly misleading. Usually when we talk about Delta neutral strategies it's using option writing. So, an actual Delta neutral position would mean that we are selling an OTM put option which has the delta of +0.4 and we are also shorting an OTM call option which are the delta of - 0.4 and thereby giving a net delta of 0 for the entire strategy.

It is usually easy to create Delta neutral strategies to start with. But when the underline moves the delta for different positions will change differently and the overall position may have a positive or a negative Delta. In the example that we took if the market starts to go up, we can expect that the put option will start becoming more OTM and hence the delta will reduce to 0.3. On the other hand, the call option shorted will gradually become ATM and hence its delta will be close to -0.5. The overall delta of the position has changed from 0 to -0.2 and hence a downward bias.

Example With Index Near 23,000

Assume the index is trading around 23,000.

You create a short strangle:

Sell 23,300 Call option with delta = -0.2 (2 lots)
Sell 22,700 Put option with delta = 0.2 (2 lots)

At entry, combined delta may be close to zero.

But if price moves to 23,200:

Call delta increases to -0.4 (2 lots)
Put delta decreases to 0.1 (2 lots)

Net delta becomes -0.3 x 2 = -0.6. Now the position behaves directionally. Risk increases if price continues moving. Balancing delta helps maintain non-directional exposure.

How Traders Maintain Delta Neutrality

The aim of the traders is to ensure that the entire position's delta is closed to zero. There are multiple ways a trader can maintain delta neutrality. Delta neutrality is usually maintained through adjustments. Some of the common methods include:

1. Adjusting the strike positions: In our previous example in which the deltas become -0.6 a trader can shift the entire position a little up. That means the trader can exit the original 23300 call option under 22700 put option and take new positions as 23500 call option (sell) and 22900 put option (sell). 
2. Reducing exposure on one side: In this case that trader may reduce some positions and add few positions. For example the trader can exit one of the call positions and short two more lots of put option and their by making the net Delta zero. The call delta = -0.4 (1 lot) and put delta 0.1 (4 lots) = 0.4
3. Using futures to hedge directional exposure : In case there is a very strong direction move one very good method of maintaining the Delta neutrality is to take the trade in futures. The Delta of futures is 1 (long) and -1 (short). So in case if the net delta of the position is close to -1 trader can just long one lot of future so that the overall Delta become zero.

Summary

Delta neutral strategies are very rewarding because a traders are only worried about the profit they are making by theta decay. However the strategy only works if the movement is small and if the overall position is closed to Delta neutral. In case the position is not Delta neutral then the trader can have risk because of the direction bias. There are multiple ways a trader can continue to have the position Delta neutral such as adjusting strike positions and reducing exposure on one side.