What is Delta Neutral
Delta neutral is a portfolio strategy utilizing multiple positions with balancing positive and negative deltas so that the overall delta of the assets in question totals 0.
BREAKING DOWN Delta Neutral
A delta-neutral portfolio evens out the response to market movements for a certain range to bring the net change of the position to 0. Delta measures how much an option's price changes when the underlying security's price changes.
As the value of the underlying assets changes, the position of the Greeks will shift between being positive, negative and neutral. Investors who want to maintain delta neutrality must adjust their portfolio holdings accordingly. Options traders use delta neutral strategies to profit either from implied volatility or from time decay of the options. Delta neutral strategies are also used for hedging purposes.
Delta Neutral Basic Mechanics
Long put options always have a delta ranging from -1 to 0, while long calls always have a delta ranging from 0 to 1. The underlying asset, typically a stock position, always has a delta of 1 if the position is a long position and -1 if the position is a short position. Given the underlying asset position, a trader or investor can use a combination of long and short calls and puts to make a portfolio's effective delta 0.
If an option has a delta of one and the underlying stock position increases by $1, the option's price will also increase by $1. This behavior is seen with deep in-the-money call options. 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 $0.50 for every $1 increase in the underlying stock.
An Example of Delta Neutral Hedging
Assume that you have a stock position that you believe will increase in price in the long term. You are worried, however, that prices could decline in the short term, so you decide to set up a delta neutral position. Assume that you own 200 shares of Company X, which is trading at $100 per share. Since the underlying stock's delta is 1, your current position has a delta of positive 200 (the delta multiplied by the number of shares).
To obtain delta neutral position, you need to enter into a position that has a total delta of -200. Assume then you find at-the-money put options on Company X that are trading with a delta of -0.5. You could purchase 4 of these put options, which would have a total delta of (400 x -0.5), or -200. With this combined position of 200 Company X shares and 4 long at-the-money put options on Company X, your overall position is delta neutral.