Delta Neutral: Definition, Use With a Portfolio, and Example

What Is Delta Neutral?

Delta neutral is a portfolio strategy with multiple positions balancing positive and negative deltas so that the overall delta of the assets is zero. Options traders use delta-neutral strategies to profit from implied volatility or the time decay of options. These strategies are also used for hedging. Below, we explain this strategy for novices and more experienced traders alike.

Understanding Delta Neutral

Understanding the concept of delta is crucial in options trading. Delta, one of the "Greeks" in finance, measures how sensitive an option's price is to changes in the price of the underlying asset. More specifically, delta measures how much an option's price is expected to change for a $1.00 change in the price of the underlying security. For example, a call option with a delta of 0.25 and worth $1.40 would be expected to have a value of $1.65 if the underlying asset moved $1.00 higher.

A portfolio's delta can be positive, negative, or neutral, depending on the positions held:

1. Positive delta: A positive delta means that the option's price is expected to increase as the underlying asset's price increases. This is often the case for call options or a bullish position on a stock.
2. Negative delta: Meanwhile, a negative delta means that the option's price will decrease as the underlying asset's price increases. This is common with put options or a bearish stance on a stock.

Investors aiming for a delta-neutral portfolio want to balance these deltas so that the overall delta of the portfolio is zero. This balancing act means that small, incremental moves up or down in the underlying asset price would not cause any changes to the portfolio. However, large price swings, changes in volatility, and the passage of time can still affect the value of the portfolio. Getting to delta neutral often means making continual adjustments since the delta might shift away from zero from changes in the market.

How Delta Neutral Works

A positive delta means the option's price will increase when the stock price increases and decrease when the stock price decreases. Conversely, a negative delta means the option's price will decrease as the stock price increases and increase when the stock price decreases. Let's get some more terms out of the way before laying out this strategy:

• Long and short positions: A long position indicates that you own the asset and expect its value to increase over time. A short position, meanwhile, means you're betting against the asset, expecting it to go down.
• Call and put options: These are two types of options contracts. A call option gives the holder (buyer) the right to buy an asset at a given price within a specific period. A put option gives the holder the right to sell an asset at a given price within a particular period.
• The values of delta: Long put options' deltas range from -1 to 0, while long calls always have a delta ranging from 0 to +1. The underlying asset, typically a stock, always has a delta of 1 if the position is long and -1 if the position is short. A combination of negative and positive would get the delta to zero overall.

We can now move through how a delta-neutral strategy, getting a delta of zero, would work. Suppose you have a long position in a stock (delta of +1). To make this position delta neutral, you could buy a put option on the same stock (with a delta range from -1 to 0). This behavior is seen with deep-in-the-money call options. If the stock's price increases by $1, the long position will gain $1 (because of the +1 delta). However, the price of the put option will decrease, offsetting the gain from the long position. This ensures that the portfolio's overall value remains unchanged despite the stock's change in price.

Likewise, if an option has a delta of zero and the stock increases by $1, the option's price won't increase at all (a behavior seen with deep out-of-the-money call options). If an option has a delta of 0.5, its price will increase by $0.50 for every $1 increase in the underlying stock. This is because the delta (0.5) is multiplied by the change in the stock's price ($1), resulting in a $0.50 change in the option's price.

Example of Delta-Neutral Hedging

Suppose you have a stock position of 200 shares of Company X, trading at $100 per share, that you believe will increase in price over the long term. You are worried, though, that prices could drop in the short term, so you decide to set up a delta-neutral position to hedge this directional risk.

Being long 200 shares of stock means that your delta is +200. You can find options contracts providing the opposite delta exposure to cancel that out (i.e., -200).

Say that you find an at-the-money put option on Company X with a delta of -0.50. The sign is negative because put options gain value as the underlying price declines and lose value when it rises. Options on stocks represent 100 shares of the underlying asset, so buying one Company X put would provide you with the following: -0.50 × 100 = -50 deltas.

If you bought four of these put options, you would have a total delta as follows: 400 × -0.5= -200.

With the combined position of 200 Company X shares and long-4 at-the-money put options on Company X, your overall position would not be zero, i.e., delta neutral.

Pros and Cons of Delta-Neutral Positions

The primary benefit of a delta-neutral position is that it's immune to small changes in the price of the underlying asset, either up or down. This strategy is about betting on the direction in which the stock price will move and not about having to worry about minor fluctuations in price.

Delta-neutral traders often seek to profit from options' time decay (represented by the Greek theta) or changes in implied volatility (the Greek vega) and not the directional movements in the stock. Since delta neutrality focuses on offsetting price movement risks, traders can focus on these other factors affecting the option's value.

However, being delta neutral also means missing out on those price movements, so it does present a sort of opportunity cost for some traders. Even if you are not concerned about these price changes, maintaining a delta-neutral position as the underlying moves requires active monitoring and adjusting, which can be costly and not well-suited for inexperienced traders.

In addition, large unexpected market moves can lead to substantial losses since the position is neutral only to small price movements. So, significant and sudden market events can undo the strategy.

The Bottom Line

Delta neutral occurs when a trader's net positions are hedged against changes in market price, either up or down. This is done by offsetting the deltas of one financial instrument with that of others. This balance means that small movements in the underlying asset's price will have little to no impact on the overall value of the combined position (e.g., stock plus options). The idea is that the gain on one side of the position offsets the loss on the other.

However, it's important to remember that delta is not static; it changes as the market moves (gamma) and time passes. Therefore, maintaining a delta-neutral position often requires continual adjustments, known as dynamic hedging.