In options trading, “delta” represents volatility. It is one of a set of variables, collectively known as “the Greeks, that traders use to assess the risk of a derivative. Here’s what you need to know about delta neutral investing and how it works.
Delta Neutral Investing, Explained
The delta of a derivative measures how much its price will change relative to price movements in its underlying asset. For example, a delta value of 0.5 means that the price of a derivative will change by $0.50 for every $1 that the price changes in the underlying asset. A delta value of 1 means that the prices move in tandem; in other words, a $1 change in the underlying asset’s price will change the value of the derivative by $1.
Long positions, or “call” positions when the trader is talking about options, measure volatility on a scale of 0 to 1 delta. Short positions, or “put” options, measure volatility from 0 to -1. This reflects that the former trading position looks for the price of an asset to rise while the latter looks for the price of an asset to fall. Equities, debt instruments and other non-derivative assets always have a delta of 1 or -1 for risk assessment purposes. In practice, however, this measurement is typically only used in the context of derivatives.
In either case, a volatility of delta 0 is what investors call “delta neutral.” It means that changes in the price of an underlying asset don’t change the price of the derivative at all. While that scenario is impossible in a single financial product, many traders try to build a delta neutral position overall.
Defining a Derivative
delta neutral investing
In order to understand delta neutral investing, you should familiarize yourself with derivatives first. Simply put, a derivative is any financial asset whose price is based on the value of some underlying asset.
Futures and options contracts are perhaps the most common examples of derivatives in the marketplace. When two parties enter into a futures contract they agree to buy and sell a specific commodity (or its financial equivalent) at a specific date in the future. An options contract works much the same way, except that the party who purchases the contract is not obligated to execute on it when the day comes.
The value of this contract is based on the price of the underlying asset (whichever commodity they have decided to trade) but not defined by that price. The parties will also price their contract based on how each evaluates the market, how much they need the given commodity and what they think will happen to prices over time, among other concerns.
For example, John Doe enters a futures contract to buy coffee on August 1 for $100 per bag. The current price of coffee partially defines this contract, but John will also base his position on his opinion of what will happen in the consumer market, the supplier market and even the weather between now and August 1 — all factors in the future price of coffee beans.
Building a Delta Neutral Position
Traders consider an asset’s volatility carefully before buying any derivative. While they can take steps to control their exposure to market-based risks, the price of an underlying asset typically introduces elements of unpredictability into an investment position. For this and other reasons, many investors may build a delta neutral position.
In a delta neutral position a trader has made multiple investments whose cumulative delta values offset each other, leading to a net zero. The goal is to build a position such that you will not lose money regardless of how the underlying asset moves. There are two critical things to note about this process:
First, a delta neutral position builds a net-zero position against a single underlying asset. You are not in a neutral position if you have a net-zero delta spread across several different underlying assets.
Second, the total delta of your position is calculated based on the number of assets you hold multiplied by the delta of that given position. Say a given options contract has a delta of 0.5. If you purchase 100 of these contracts, your total position will have a delta of 50 (100 x 0.5).
Let’s say you own 100 bags of coffee beans. Since this is a direct asset, each bag has a delta of 1. Your current position has a delta, therefore, of 100 x 1 = 100.
You would like to build a delta neutral position out of this. You could do so by looking for short futures contracts, which measure their delta on a scale of 0 to -1. Say you found four contracts for 50 coffee beans with a delta of -0.5 each. The delta of each contract would be -0.5 x 50 = -25. The total delta of the four contracts together would be -25 x 4 = -100. Your position would now have offsetting delta values.
In practical terms, a short futures contract allows you to profit when the price of the underlying asset falls by selling it at a greater than market price. Here, if the price of your coffee falls, you can recoup the money you’ve lost through profits on your futures position. On the other hand, if the price of coffee rises, your futures position will take a loss equivalent to any profits you make by selling your coffee beans. Your position is net-neutral.
The Payoff of a Delta Neutral Position
delta neutral investing
The real-world effect of taking a delta neutral position is that you neither lose nor gain money when a derivative’s underlying asset changes price. You have taken offsetting positions such that one set of investments gains value to offset any losses in the underlying asset’s price, and vice versa for any gains in this price.
This can have a number of benefits. Two of the most common are:
Hedging: Investors often use delta neutral investing to hedge against potential losses. This is used particularly to protect against short-term risks, as investors might build short-term delta neutral positions around long-term investments to protect against an unforeseen event.
Options trading: In an options contract, the investor who bought the contract has the choice of whether or not to execute it on the settlement date. If their position is profitable they can do so and claim their money. If they’re holding an unprofitable position they can simply walk away.
Many options traders use delta neutral positions to profit off this dynamic. They enter into mutually offsetting contracts knowing that they can keep whichever one makes money and abandon the one that loses value. A common example of this is the trading position known as the “straddle.” It is restricted, however, by the fact that options traders pay a premium for each contract they enter. A delta neutral options strategy needs the underlying asset to swing in value by enough to cover their multiple contract premiums, otherwise their position will net them a loss.
The Bottom Line
The delta of an asset is not a fixed calculation, and volatility is a best-information measurement. Investors base it on a number of factors, including the price of a derivative’s underlying asset. Over time the factors that go into a volatility calculation can change, and if they do the delta of a given derivative can change with it. This is particularly likely if the price of an underlying asset swings significantly. In those cases it’s not unusual for a derivative’s volatility metric to suddenly — and even substantially — change.
As a result, delta neutral positions are not fire-and-forget investments. If you want to build one, you need to monitor it over time and be prepared to make changes as necessary.
Tips for Investors
Volatility can mean big gains — or just as big losses. If you want to protect yourself against those kind of risks, try a 60/40 portfolio.
If you want to know if a delta neutral options strategy is right for you, consider speaking with a financial advisor. Finding the right advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in just 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
