You can trade options if you have a view that the market is mispricing volatility of an underlying asset. This week, we discuss delta-neutral trades and the issues associated with such trades.
A delta-neutral trade is one where a trader creates a position in an option and its underlying asset such that the delta of the total position is zero. Suppose you buy a call option on a stock and the position has positive delta. To make the overall position delta-neutral, you must short appropriate number of shares of the stock, a delta of an option approximates the change in the option price for a one-point change in the underlying. The delta of an underlying is one, as it is the change in the underlying with respect to itself. So, a long position in two calls each with a delta of 0.50 can be made delta-neutral with a short position in one share of the underlying stock.
A delta-neutral trade is a bet on the relationship between the expected volatility of the underlying and its actual realised volatility. The implied volatility of options is somewhat indicative of the expected volatility of an underlying. So, if the trader believes that the implied volatility is low and that the actual volatility of the underlying at option expiry is likely to be higher, the trader ought to buy calls and delta-hedge the position with short stock. Conversely, if the trader believes that implied volatility is high, the trader should buy the stock and delta-hedge with short calls.
Consider the practical issues relating to delta-neutral trades. For one, shorting a stock has associated costs. So, traders prefer short futures instead of short stock. For another, you need to determine the nature of the underlying’s volatility. If underlying’s volatility is high today, is it likely to remain high for some time or is it likely to decline? This is important because you ought to maintain delta-neutrality till you close the position. This requires adjusting the position frequently because option delta changes as the underlying moves up or down after you setup the position. Now, frequently repositioning the trade increases transaction costs. Importantly, you may be unable to always create a perfect delta-neutral trade because of pre-defined permitted lot size for option contracts.
The upshot? If you believe that implied volatility of calls is currently high or low and do not want to take a directional bet on the underlying, then you could setup a delta-neutral trade using futures (or stock) and an at-the-money (ATM) call.
Delta-neutral trades on the Nifty Index could be setup using long positions in the near-month futures. Note that trades involving ATM options closer to expiry are preferable. For one, implied volatility is a component of time value and time decays faster as an option approaches expiry. For another, the need to adjust your position to maintain delta-neutrality is lower when time to expiry is shorter.
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