Dumbstruck by the consequences of Delta Neutral Trading

Hi there folks,

This is my first post here so please go easy on me LOL

I have been trading for a couple of years now, started off with equities, then warrants, then CFD’s and Spread trading and eventually settled on spot forex. I suppose we all walk our own road to trading maturity somehow and that has been mine. Currently I am at the point where I have taken a keen interest in using options to establish market neutral positions.

I understand options concepts and all the strats and math’s etc. etc., not new to options and derivatives either. Over time I have read books, articles blogs etc. etc. as anyone with a keen interest would do and also trade my own concoctions live. I have however now stumbled across a wall in my way to understanding some concepts and hope that by interacting here on this forum, some kind soul could help me move along again.

Looking at the following example, you might be able to see my angle and correct my faulty reasoning. I really DO hope I am missing something here because I would really like to move over to some form of neutral strategy. I understand the underlying principle and can even create a Delta-Gamma neutral position…the actual creation of these trades is not my problem at all, I am simply dumb struck by what happens when the market would take of in one direction only and you eventually run out of futures to dump and still have not recovered the premiums on the puts or you accumulate a ton load of underlying to lock option profits and do not get a chance to sell them higher to actually put your hands on the profit…

Anyhow, here is the example, perhaps it will bring us to the same page of this interesting chapter of Delta Neutral trading.

Instead of using futures contracts I use spot forex combined with vanilla put options.

So say I go long 20000k spot EurUsd and long 40000k puts (10000k = 1 contract so I need 4 option contracts in essence. My position is Delta neutral and we are set. We have paid premium of $370-00 for the 4x29day put options plus spread costs on the spot trade as well which is minimal.

If Euro starts moving lower we would be adding to our spot long side at specific delta hedge imbalances. We do this to lock in the accumulated profit of the option side. We do not actually get this profit at this point in time. We do this because in actual fact strictly speaking, the profit is lying on the Put Option side, but we do our balancing on the spot side. We do thus not get the open options profits, we are simply locking them in for IF the market trades back up to allow us to dump them and collect the locked in profits.

If the market continues dropping, we will continue adding to the spot long side until such time the market moved back up to allow us to start cashing out some of the locked profits. To be more precise, if we wish to collect ALL the locked in profits, the market has to move back to exactly where we started the initial positions.

The problem I thus foresee is that we are assuming mean reversion to our initial entry point. This is a big mistake I recon. Sure yes, prices tend to revert to their mean, but we can not possibly trade the mean or average, only the real prices. If trend sets in we may never see our entry point again for months. Extending the lifetime of the option will not really help either because the premium will escalate in tandem.

For this reason I believe this particular delta neutral strategy not to be directional neutral because a constant down move can leave us with unrealized locked in profits which will become totally worthless if the option expires and price did not move back up to allow us to collect the profits at the different levels we added on. Our expired puts will cover our capital loss on the long spot trades, and we would not be able to add on more pieces when we reach a level of 40000k on the spot. This is because that is all we have downside protection for using the 40000k options, any additional add-ons will be unprotected.

So perhaps now you see my angle and can shed some light onto this subject. Like I said, I really do hope I am missing an important link which is how to get the locked in profits from when the market does not move back up before expiry. The only solution I can come up with is to perhaps only use the spot side to adjust up movement and adjust down movement by buying selling options again. This way we immediately take the profits and we break our dependency on a false hope that price will revert all the way back up to give us chance to take profits.

When price goes up however, after entry, I can see how we can make a few pennies perhaps, but it also has its limits when considering Euro’s range potential.

So in summary then, when the market moves above our entry points, we can take immediate profits, when it moves below our entry point, we can only book unrealized profits until the market moves back up, leaving us with the risk that it might never move all the way back up again and in the end we are still left with an uncovered premium.

Of course there is the a different side to this which relates to the market possibly oscillating up and down in a range, thus allowing us to accumulate spot fx and dump higher – this I can understand, but gees, how many oscillations will it not take to cover the mere premium.

In the above example I simply used Euro/USD, I know the volatility is not that great, but the logic applies to any pair I suppose.

Hope you have a better solution.

Best wishes,

 

In a "gamma scalping", or straddle scalping (if you are protecting your spot position with both puts and calls), a continued move in one direction will not result in profits, unless there are more "deltas" in the protective options, than you are long/short spot and the spot/underlying moves far enough.

The "back and forth" movement of the underlying is crucial, so that profits may be taken under the option protection - hence the term "scalping".

At least that's the way I've played it, and if I understand your question.

The only thing to do AFAIK is hang on. As long as the underlying is fully protected, You are just losing the long prem paid.

"Reset" the game after expiry to new center strikes and try again. Hopefully some others can give better advice.

Regards.

 

There's no solution, as Wayne has pointed out above, the oscillation is required for gamma scalping. If the underlying starts to trend then you keep fading it when you adjust your deltas. This strategy like any other has its risks and rewards, it's not the holy grail.

 

Thank you kindly for your replies guys,

The crux of your reply confirms my suspicion that this kind of play would only work out in a heavily oscillating market. These currency premiums for say 1 month out are quit hefty so I suppose one would need a heck of a lot of oscillating to cover that dent, unless there is some trick to the ratios between the quantity spot held in conjunction with the quantity options – but then again, it would not really be delta trading anymore.

I read in a book about ratios 2:4 and 5:10 etc. Would this mean one could perhaps cover these cost faster?

I was hoping to simply buy say 4 option puts to cover an open quantity of spot and adjust the spot, but whatever I try, no matter how crafty I get, in the end I come to the same conclusion….the option pricing models are very “clever” and each fo the cases I examined, to cover cost or break even would mean price would need to range just about what it’s average monthly range is, it’s incredible. The odds are thus basically 50/50 no matter what I try.

This is worse then that darn Rubik Cube – I could never get those colors right either, always ended up disassembling the thing and putting it back together again, I guess there is no such shortcuts in this options game

Once more thanks for you reply!!!

Best wishes,

Digital Nomad

 

I haven't found it crucial at all. Nice if it does it that way though. As long as the position manufactures deltas faster than theta eats away profit, it doesn't matter if direction is all one way.

You may have to adjust your strike however as the gamma curve becomes unbalanced.

 

Trouble is whenever I put on one of those, all volatility and movement dies!

 

Yeah, the planets have to line up right hey.

"Don't just stand there, DO something!"

 

I’m sure the market has a very deeply hidden wicked little sense of humor sometimes LOL

 

I must be reading this wrong or not clueing on to the discussion yet, but you have a synthetic straddle position, in which gamma scalping is an option, but a straddle is a straddle. If the trend is established, you will as said be net short or long deltas into the trend which is a good thing. Losing the premium is only a concern if you cannot scalp enough to pay for decay or if the underlying doesn't move enough to manufacture deltas. So with that all said, I don't see the problem. If there's great oscilations, scalp, if trend, hold position. Where are you losing?

 

The losing bit comes from not acknowledging there's a trend and trading the spot against it.