Friday, February 20th, 2015

how does one trade the volatility in options with delta neutral trading?

I have friends that the volatility of trading options. I do not know how, but the use of strategies with minimal risk, regarless market direction and profit consistent. Can anyone explain how?

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2 Responses to “how does one trade the volatility in options with delta neutral trading?”
  1. Dinesh says:

    Delta Neutral is easier to understand than it sounds. Delta is one the 5 commonly used “greeks” of option price behavior. Delta is the usually shown as the change in option price for a 1 dollar change in stock price. Naturally, Call deltas are positive and Put deltas are negative. Not only that, Call delta can range from 0 to 1, and put deltas from -1 to 0. If you consider it this way, you can safely say that delta rises as stock price rises, and falls as stock price falls. You can also see that deep in the money delta should be nearly +1, and deep out of money put delta be nearly 0. There are lots of interesting tidbits of “knowledge’ here. Delta calculators are dime a dozen, although one still has to calibrate them so that the given prices match what’s observable in the market.

    Combine another piece of fact — delta of a stock is always 1. Obviously, a one dollar change in stock leads to one dollar change in stock :-)

    The setup is all visible now. When your friend writes a call, he (or she) simultaneously purchases “delta fraction” many stocks to hedge. E.g., if he wrote 20 calls of XYZ and delta was 0.57, he also buys 1140 shares of XYZ. So the net delta of the “portfolio” is zero. For small moves in stock prices, stock/option moves are hedging reasonably . (This is the so called “buy high sell low” strategy — if stock moves higher, you buy, if it moves lower, you sell. Take a pencil and paper and work it out yourself with a couple of examples.)

    It’s all well and good until the stock has a jump. Then another of the greeks – gamma – can gang up on you and cause larger than expected losses to your position. Because Delta alone is useful only for modest changes in prices. So, this needs careful watching. The risk of jumps is common to stocks but less so with Indexes.There is a more complex Delta-Gamma-Neutral strategy to deal with that. Then, there are additional issues such as increase/decrease in volatility. That by itself can cause an option price to rise/fall.

    One must be familiar with these greeks before jumping into derivatives trading. These can become WMD if you didn’t understand them well. The “M” is there to remind you of the wonders of leverage.

    Hope this was useful in whetting your appetite to learn more about Greeks.

    There is a wonderful book on derivatives by John C Hull. It has a chapter on Greeks. Despite all the math (which you might follow or then might not) if you read it, I can assure you you will not become less intelligent.

  2. zman492 says:

    First, I want to let you know I agree with the answer by Dinesh. I do not, however, believe it answered your core question about how to trade volatility.

    Second, the statement “they use strategies with minimal risk, regardless of market direction and make a consistent profit” probably should be “they believe they use strategies with minimal risk, regardless of market direction and make a consistent profit.” For every 10 option traders who think they are making a consistent profit with minimal risk, at least nine are taking more risk than they think they are. I do not know how much risk your friends are taking, but I do know I have seen a lot of people make consistent small profits for a time, only to see one or more massive loss later that wipes out months or years of small gains. Most of these people were not dumb. One of them, Myron Scholes, had won a Nobel prize in economics for his work on options.

    You already got something of an explanation of a delta neutral spread. A spread is a combination of two or more offsetting positions. If the sum of the deltas of all the positions in the spread is close to zero, it is considered delta neutral. That means your friends are trading spreads that do not change much in value when the stock price moves a small amount.

    Insread of trying to make money by predicting what direction the stock price will move, they are trying to make money predicting how volatile the stock price will be. You need to understand there are three types of volatility.

    Historical volatility (HV) measures how volatile the stock price has been in the past. It is also sometimes called statistical volatility (SV).

    Implied volatility (IV) measures how volatilite the stock price will be prior to expiration of an option to make the option fairly priced. For all practical purposes this is determined by supply and demand. When more people want to buy options on a stock IV goes up. When more people want to sell options an a stock IV goes down.

    Expected volatility (EV) is the amount of volatility a trader expects in a stock over a time period, usually up until an option expires. Every trder determines EV differently and they get different results.

    When EV is significantly different than IV and option trader will want to make a trade. If EV > IV he will want to buy volatility. When EV < IV he will want to sell volatility.

    Just as delta measures how much the price of an option changes when the price of the underlying stock changes, “vega” measures how much the price of an options changes when implied volatility changes by 1%.

    Some things you should know about vega:

    o All long options positions have a positive vega.

    o All short option positions have a negative vega.

    o At the money options usually have a higher vega than options with strike prices further away from stock price.

    o Longer term options options usually have a higher vega than shorter term options.

    So, if I want to buy volatiity, I want a spread where I buy more options than I sell, where I buy options closer to the money than the options I sell, and/or where I buy options with longer terms than the options I sell. Examples include:

    backspreads
    long straddles/strangles
    ATM put or call winged spreads opened for a credit
    long time spreads

    If I wanted to sell volatility, I would want the exact opposite of the above spreads,

    ratio spreads
    short straddles/strangles
    ATM put or call winged spreads opened for a debit
    short time spreads

    Unless you are quite familiar with options I do not expect you to understand everything I wrote. I suggest you read some good books about options before trying to trade volatility. The other answer recommend Hull. My recommendations are

    Options as a Strategic Investment by McMillan
    Option Volatility & Pricing by Natenberg

    but Hull’s books are considered among the best as well.

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