How do you rebalance delta neutral trades?

Discussion in 'Options' started by badbart, Nov 20, 2008.

  1. badbart


    I’ve been trading long stock and long puts to make my stock holdings delta neutral. Of course with the market getting hammered I’ve had some really good returns. For example I hold GE and as my GE falls my puts rise and I have to either sell puts or buy more stock. I usually sell my entire position of puts and buy lower strike put as the lower strike puts become ATM. What is better selling the puts or buying more stock? The stock commission is cheaper but the puts have done extremely well for me.
  2. As with most aspects of options trading, there is no 'best' method.

    Most professional traders who adopt the concept of trading 'neutral' - and that's almost all of them in today's market maker world, have more than one method from which to choose.

    You want your position to be sized correctly so that you don't build a gigantic position with more risk than you want to accept. When you have a choice between seling puts and buying stock, be certain you don't end up owning more stock than you want to hold. I know there's no downside risk because the puts offer full protection, but as those put deltas approach -100, you are not going to have much left - except for a bucketful of naked long calls (the equivalent to stock plus put)

    Here are some alternatives:

    1) Every time the stock moves x points, buy or sell shares to once again become delta neutral.

    2) Every time the stock moves one (or two) standard deviations, again adjust by buying or selling shares.

    Instead of trading shares, you have chosen to keep your stock and adjust the puts. And you apparently do this every time a new series becomes ATM - and that means every 2 1/2 points.

    I like this idea. It keeps you from building a monster position and it allows you to maintain a put holding that always has significant gamma.

    The problem from my perspective is how often does GE give you a chance to adjust the deltas? With options being a wasting asset, do you like the idea of neutralizing your deltas every 2.5 points? Would 1.25 points be better (I don't know the answer - it's a personal decision for you to make). But, this has been working well, so no major charges are needed.

    But - don't ignore the importance that a huge jump in the implied volatility in contributing to your profits. At some point that IV level will not be maintainable. An IV crush will hurt.

    And don't ignore the risk (although the reward is substantial) of holding options too along and watching the time decay eat your profits.

    Congrats on a nice trade - or series of trades.

  3. If you're making profits on hedged long stock, you've got to have more puts than round lots otherwise you'd be racking up larger paper losses than realized gains (duie to the stock's delta being greater than the option delta). If that's the case, I think it's more luck than anything (a cooperative hammered market with rising IV) because to succeed at delta neutral trading, one tends to need an edge (timing of stock, being on the right side of the IV change, etc.).

    But to answer your question, I believe that you should always be booking profits and carrying the losses... and that booked gain should exceed the paper loss, In the case of hedged long stock in a down market, it's the puts that will appreciate so that's the side that you should work (roll them and maintain the ratio).
  4. badbart


    I've been very lucky, right now I'm long 89 JAN 14 Puts and Long 4,000 shares of GE stock. The Delta is 256 long on the puts. Today I might liquidate the entire put position.
  5. Congratulations on employing a successful strategy in this market. You've hedged much better than I, that's for sure:D . I stock by my handle and have been writing calls all the way down, but that hasn't nearly kept up with the market fall. I entered some risk reversals yesterday at the close and hoping to get some money out of them today on this bounce.
  6. badbart


    I closed out the GE puts when the market opened and shorted OEX Nov 355 Puts.
  7. In the stock market, it's better to be lucky than smart (g).

    Ratioing long puts to your stock works quite nicely in a market like this. It won't work as/so well if the market levels off and IV contracts.

    Another game you can play to generate additional income is to write some OTM covered calls against your position (a collar). Itg can be under/ecven/over ratioed, depending on your outlook and risk management ability. That will decrease the cost of your protective puts and assumes that you're willing to give up a chunk of the upside profit potential. As with the puts, as the underlying drops, you can roll them down as well, booking add'l profit.
  8. Puts are expensive these days, and covered calls are obviously risky. There is a simpler way. Take your 4,000 sh of GE. Market value is $56,120.00. To hedge, go short the SPY or even the ES future. If choosing the SPY, short 705 shares. Betas are about the same. You can also, if you have access--like an IB account, short the ES futures. You can short 1 ES FUT. The SPY hedge is much closer to your GE stock's value. The ES hedge is about $16,000.00 less, so it is more of a partial hedge. Once the current "rally" fizzles out in a day or two, that would be a good time to put on the hedge. If you believe that the current "rally' will be extended, then there is no need to hedge.