Ways to profit from Delta Neutral strategy
The most misunderstood and wrongly applied aspects of options strategies are Greeks. Many options traders do not look at Greeks, as very few resources are available to track them. It’s not usually preferred as it is difficult to understand them and build a proper strategy.
Delta is one such Greek that is primarily used but misunderstood. All the hedge funds use Delta as a tool to build strategies. Delta measures the rate of change of options premium based on the directional movement of the underlying. It means if at-the-money (ATM) options strike Delta is 0.50 and the underlying moves one rupee, the option premium moves less than a rupee i.e. 0.50. The OTM option premiums will have less than 0.50 Delta, and ITM options have over 0.50 Delta. All the OTM Deltas will become zero at the expiration, and ITM options will have Delta close to 1.
As the put options have the inverse price relationship with the call, Deltas also have an inverse relationship, which means that put options have negative (minus) Delta. If you have a stock in your portfolio, it will effectively have a Delta value of 1. So, let us examine, how one can benefit from Delta while trading in options?
Profit from time decay
The time always decreases. When you buy an option, it is negative, and when you sell or write an option, it is positive. We can create a delta neutral position by writing the options to benefit from the time decay. So that, any small movement in the price of the underlying will not affect the position much and one would not lose money. For example, the ATM call option will have +0.50, and ATM put option will have -0.50 Delta. If we apply a short straddle, i.e. sell call and put of ATM, it will have a 0 Delta. This is nothing but Delta's neutral strategy. A small price movement on either side or expires at the strike you applied, then the option premiums will become worthless. Even if the underlying price moves significantly, one option premium becomes zero, and the other one goes into loss. However, you can close the position at an early stage. Generally, as near as to the expiry, the probability is higher to get the profit.
Profit from volatility
Volatility is one of the most important factors, which can influence option premiums. Any stock or index which experiences higher volatility will have higher premiums at the beginning of the series. At the time of events like earnings, or policy decisions, they also have higher premiums. In such cases also, the Delta neutral strategies work well in favour of your positions. To profit from the volatility, buy the call & put (ATM) options. The maximum loss here is to the extent of the premium paid. If the stock experiences volatility as expected, one option will become worthless, and the other will have unlimited profit potential. The word of caution here is that you should apply this strategy near to the expiry. Apply this strategy only if you are confident of big price movements in the underlying security or index.
Profit from hedging
Options are basically designed to hedge the portfolio. They can protect from unexpected movement in the price, which is against the portfolio. All the hedge funds use options as a tool to hedge the portfolio. Delta neutral strategies to hedge the portfolio are a popular method to use. For example, if you have a stock in your portfolio equal to the derivative lot size. Delta of your stock is one. You can hedge this by buying two lots of ATM puts or selling two lots of ATM calls. So, the options will also have one Delta. If the stock prices plummet, the options will give compensation for the loss. If the stock price moves upside, the options will have negative returns, which can compensate for the stock price movements.