Delta Neutral Trading Can Be Dangerous: What Not to Do and How to Fix It
There are benefits to delta-neutral trading. One of the primary benefits is that it can help you minimize your risk. By hedging your portfolio against directional risk, you can reduce the impact of market fluctuations on your portfolio. Additionally, delta-neutral trading can help you take advantage of opportunities in the market without taking on too much risk.
What is Delta Neutral Trading?
There are a few key components to delta-neutral trading. First, you need to understand delta. Delta is a measure of the change in the price of an option relative to the change in the price of the underlying asset. A delta-neutral portfolio has a delta of zero, which means that the portfolio is not affected by changes in the price of the underlying asset.
Another key component of delta-neutral trading is gamma. Gamma is a measure of the rate of change of delta with respect to changes in the price of the underlying asset. A gamma-neutral portfolio has a gamma of zero, which means that the portfolio's delta is not affected by changes in the price of the underlying asset.
One common mistake that traders make when trying to create a delta neutral position is using the wrong trade structure. Many traders use traditional premium selling trade structures, which can be highly directional and cause significant losses due to large delta adjustments when an underlying changes direction. When the underlying price changes direction in a back-and-forth manner and continuous adjustments are made with every move it causes directional whipsaws. These inefficiencies can cause losses on whipsaw, just like in directional trading.
While traders are trying to profit from Theta, they are locking in losses on direction. These losses can frequently outpace the Theta decay that was expected from the trade, requiring traders to make up for those losses over time. Therefore, it is important to slow down and diagnose the real problem before trading structures that require large and frequent delta adjustments.
Adjusting a position using delta hedging is different than using delta hedging to open and close positions. Some trade structures require legging in to establish and legging out to exit. Opening or closing a position is the time to use large delta hedging techniques as a temporary fix to large delta swings when legging into and out of positions.
On February 6th, 2018, I experienced losses due to neglecting delta-neutral concepts while exiting my options positions. The previous day's market crash had caused significant losses in my portfolio, but I was pleased to see a $50,000 increase in its value. However, in my haste to take advantage of this turn of events, I closed all positions quickly without considering delta risk. As I was not using single ticket orders, I had to leg out of positions, and as I closed one position, the others became directional. Despite believing that I could close my positions fast enough to avoid significant directional losses, I ended up with a net liquidation value that was -$80,000, which was devastating. This $130,000 swing was solely due to my lack of attention to delta neutrality while legging out of positions.
As you can see proper delta neutral trading is important as you can take significant losses when bad trade structures are used that force too many adjustments, too large of adjustments or legging in and out. Traders should always consider the correct way to use delta neutral trading. In order to properly use delta-neutral trading and adjustments, traders need the proper trade structure and a trade plan that focuses on gamma neutrality and super low delta swings along with single ticket orders to avoid directional legging risk. This allows traders to make low-delta adjustments and minimize the need for frequent adjustments, reducing the risk of locking in losses.
Seek Education and Training
Even advanced options traders may not know enough to properly use delta neutral strategies properly. Therefore, seeking out education and training from a high-level experienced trader can be critical.
Numerous trading platforms provide educational resources on options trading, including delta-neutral trading. However, it's crucial to exercise caution regarding the trade structures used. If the structure is a commonly used one, such as iron condors, spreads, or symmetrical butterflies, it may be wise to reconsider. Instead, there are more advanced and relatively unknown options trading structures available that can safeguard against the potential hazards of delta-neutral trading.
Traders should regularly monitor their positions to ensure that they remain gamma-neutral and have super low delta swings. This means analyzing their options portfolio on a regular basis, using tools like delta, gamma, and Theta to track changes in their positions.
Additionally, traders should have a plan in place for how to handle their remaining positions if adjustments need to be made. By monitoring their positions regularly, traders can stay on top of changes in delta and make adjustments as needed to minimize their risk and increase their chances of success.
Additionally, traders can seek out mentorship or coaching from experienced traders who specialize in advanced options trading. These individuals can provide valuable insights and advice on delta-neutral trading, as well as offer personalized feedback on a trader's specific approach to the strategy.
By seeking out education and training, traders can improve their knowledge and skills in delta-neutral trading and increase their chances of success.
Delta-neutral trading can be an effective way to minimize directional risk and profit from Theta in the options market. However, there are some common pitfalls that traders need to be aware of in order to avoid losing money. By slowing down, diagnosing the real problem, considering delta risk, using a proper trade structure and plan, and seeking education and training, traders can minimize their risk and increase their chances of success in delta-neutral trading.
Ultimately, the key to success in delta-neutral trading is having a solid trade structure and trade plan. By following these tips and best practices, traders can improve their knowledge and skills in delta-neutral trading and maximize their profit potential in the options market.
About the Author: Karl Domm's 29+ years in options trading showcases his ability to trade for a living with a proven track record. His journey began as a retail trader, and after struggling for 23 years, he finally achieved
consistent profitability in 2017 through his own options-only portfolio using quantitative trading strategies.
After he built a proven trading track record, he accepted outside investors. His book, "A Portfolio for All Markets," focuses on option portfolio investing. He earned a BS Degree from Fresno State and currently resides in Clovis, California. You can follow him on YouTube and visit his website real-pl for more insights.