Delta? How to become Delta Neutral?

Discussion in 'Trading' started by 76132, Apr 30, 2011.

  1. 76132

    76132

    I'm reading Natenberg's Option Volatility & Pricing and have a quick question about becoming delta neutral.

    Don't know how many of you guys read the book, but in it he says the underlying asset will always have a delta of 100 (long position) or -100 (short position).

    So to become delta neutral, he says you can just add up the deltas so that it equals zero. So for example, if a call option has a delta of 50, you can buy two call options and then short the underlying asset to get: 2(50) + -100 = 0. This makes you delta neutral.

    My question is, don't equity options reflect 100 shares of the underlying asset? So don't you need to short 100 shares of equity in order to be delta neutral (instead of 1, which is what Natenberg makes it sound like in his book)?

    Thanks!

    Edit: I should have posted this in the Options forum. Please move this threads mods.
     
  2. Visaria

    Visaria

    You are right, you would sell 100 shares.

    Sheldon is probably referring to futures. So you would sell 1 futures contract to go delta neutral.
     
  3. 76132

    76132

    Ah that makes sense. All these options books keep on explaining things from a futures options standpoint. I'm also reading Baird's book on Option Market Making and its the same thing.

    Thanks by the way.
     
  4. I'm afraid you boys are wrong. Here's why: an ATM (at-the-money) option does represent 100 shares of the underlying typically, but it will not have a delta of 1. Usually, the delta will be right around 0.50 just like Natenburg states (by the way, his works are considered the industry standard).

    Now, you may ask why is the delta not 1.00? Well, you may have noticed that the ATM option is not priced at $0 even though if the option expired right that second it would be worthless. The difference is the "time value" which is a reflection of the fact that in the time remaining in the option's life it could go in the money and become profitable. Because this time value is there, the price increase of the option relative to the stock price increase is not on a 1:1 basis. (If it was, the option would become greatly overvalued relative to the stock as the price of the stock increased) If you purchase an ATM option and the price of the stock rises, the delta will rise as you go upward, which also reflects two facts-- there is less time remaining for the stock price to lose value and the likelihood that you will get to keep the premiums improves as the price of the stock rises. A deep-in-the-money option will have a high delta (0.9 or higher, but not quite 1 typically). At this point, most of the time value will have been lost, but the option will have increased in value greatly due to the delta.

    Hopefully, this makes sense for you folks. If you are still confused, ask away, and I'll try to help.
     
  5. Visaria

    Visaria

    No-one said it did. Perhaps u should reread the above posts?
     
  6. piezoe

    piezoe

    I'm afraid those boys are right.
     
  7. That's pretty much it in a nutshell. Next step, Gamma scalping and charting Implied Volatility.

    Cottle's "The Hidden Reality" is pretty good also.
     
  8. Visaria

    Visaria

    I read Macmillan when I was an option MM. I hear now that the book Dynamic hedging: managing vanilla and exotic options by Nassim Taleb is the one to read.

    I read a bit on google, (just do a search) and it seems really fascinating! I'm going to buy it.
     
  9. Natenburg does not say 1 share for 1 option as the OP states! He talks about 100 shares for each option (ie a board lot). It is of course 100 shares for each option. On that, we will be agreed.

    Now for the rest of YOUR reading Visaria et al!!

    You completely ignored the rest of my post. Staying delta neutral is a dynamic process that requires adjustments as time progresses. It is a nice idea in theory. In practice, it requires regular attention.

    Here is the rest of my post for your reference:

    "Now, you may ask why is the delta not 1.00? Well, you may have noticed that the ATM option is not priced at $0 even though if the option expired right that second it would be worthless. The difference is the "time value" which is a reflection of the fact that in the time remaining in the option's life it could go in the money and become profitable. Because this time value is there, the price increase of the option relative to the stock price increase is not on a 1:1 basis. (If it was, the option would become greatly overvalued relative to the stock as the price of the stock increased) If you purchase an ATM option and the price of the stock rises, the delta will rise as you go upward, which also reflects two facts-- there is less time remaining for the stock price to lose value and the likelihood that you will get to keep the premiums improves as the price of the stock rises. A deep-in-the-money option will have a high delta (0.9 or higher, but not quite 1 typically). At this point, most of the time value will have been lost, but the option will have increased in value greatly due to the delta."

    Cottle is very good and his graphs are first rate.
    McMillan is OK, too.
    Nassim Taleb thinks a great deal of himself. I understand that he ran a hedge fund based on his ideas and it had to close down due to lack of profitability. I have read " The Black Swan" and it was interesting but not spectacular.
     
  10. Visaria

    Visaria

    Yes, well aware that staying delta neutral is a dynamic process and only really works if the underlaying doesn't have an abrupt move.

    Thank you for the rest of the explanation John.
     
    #10     May 1, 2011