Direction Neutral versus Direction Indifferent

In the world of nonlinear trading, there are two possible nondirectional views of the underlying asset: direction neutral and direction indifferent.Direction neutral means the trader believes the stock will not trend either higher or lower. The trader is neutral in his or her assessment of the future direction of the asset. Short iron condors, long time spreads, and out-of-themoney (OTM) credit spreads are examples of direction-neutral strategies.

These strategies generally have deltas close to zero. Because of negative gamma, movement is the bane of the direction-neutral trade.Direction indifferent means the trader may desire movement in the underlying but is indifferent as to whether that movement is up or down.Some direction-indifferent trades are almost completely insulated from directional movement, with a focus on interest or dividends instead.

Examples of these types of trades are conversions, reversals, and boxes, which are described in Chapter 6, as well as dividend plays, which are described in Chapter 8.Other direction-indifferent strategies are long option strategies that have positive gamma. In these trades, the focus is on movement, but the direction of that movement is irrelevant. These are plays that are bullish on realized volatility. Yet other direction-indifferent strategies are volatility plays from the perspective of IV.

These are trades in which the trader’s intent is to take a bullish or bearish position in IV.Delta Neutral:To be truly direction neutral or direction indifferent means to have a delta equal to zero. In other words, there are no immediate gains if the underlying moves incrementally higher or lower. This zero-delta method of trading is called delta-neutral trading.A delta-neutral position can be created from any option position simply by trading stock to flatten out the delta. A very basic example of a deltaneutral trade is a long at-the-money (ATM) call with short stock.

Consider a trade in which we buy 20 ATM calls that have a 50 delta and sell stock on a delta-neutral ratio.Buy 20 50-delta calls (long 1,000 deltas)Short 1,000 shares (short 1,000 deltas) In this position, we are long 1,000 deltas from the calls (20 3 50) and short 1,000 deltas from the short sale of stock. The net delta of the position is zero. Therefore, the immediate directional exposure has been eliminated from the trade.

But intuitively, there are other opportunities for profit or loss with this trade.The addition of short stock to the calls will affect only the delta, not the other greeks. The long calls have positive gamma, negative theta, and positive vega. Exhibit 12.1 is a simplified representation of the greeks for this trade.With delta not an immediate concern, the focus here is on gamma, theta, and vega. The 11.15 vega indicates that each one-point change in IV makes or loses $115 for this trade. Yet there is more to the volatility story.

Each day that passes costs the trader $50 in time decay. Holding the position for an extended period of time can produce a loser even if IV rises. Gamma is potentially connected to the success of this trade, too. If the underlying moves in either direction, profit from deltas created by positive gamma may offset the losses from theta. In fact, a big enough move in either direction can produce a profitable trade, regardless of what happens to IV.Imagine, for a moment, that this trade is held until expiration.

If the stock is below the strike price at this point, the calls expire. The resulting position is short 1,000 shares of stock. If the stock is above the strike price at expiration, the calls can be exercised, creating 2,000 shares of long stock.Because the trade is already short 1,000 shares, the resulting net position is long 1,000 shares (2,000 2 1,000). Clearly, the more the underlying stock moves in either direction the greater the profit potential.

The underlying has to move far enough above or below the strike price to allow the beneficial gains from buying or selling stock to cover the option premium lost from time decay. If the trade is held until expiration, the underlying needs to move far enough to cover the entire premium spent on the calls.The solid lines forming a V in Exhibit 12.2 conceptually illustrate the profit or loss for this delta-neutral long call at expiration.

Because of gamma, some deltas will be created by movement of the underlying before expiration. Gamma may lead to this being a profitable trade in the short term, depending on time and what happens with IV. The dotted line illustrates the profit or loss of this trade at the point in time when the trade is established. Because the options may still have time value at this point—depending on how far from the strike price the stock is trading—the value of the position, as a whole, is higher than it will be if the calls are trading at parity at expiration.