Delta-Neutral Trading-Opportunities and Risks for Speculators

Speculators attempt to profit by forecasting direction. A speculator buys stock, buys calls, or sells puts because the forecast is bullish. In the case of delta-neutral trading, speculators must forecast the direction of implied volatility, the direction of realized volatility, and the relationship between the two. If implied volatility is deemed to be low,
and if realized volatility is forecast to rise, then a speculator might attempt to profit from this forecast by buying options delta-neutral, as explained in the long volatility example discussed earlier.

Alternatively,if implied volatility is deemed to be high, and if realized volatility is forecast to fall, then a speculator might attempt to profit from this forecast by selling options delta-neutral, as explained in the short volatility example.In an effort to make a profit from delta-neutral trading, speculators assume risk over a period of time that is several trading days at minimum and several weeks at maximum.

Hypothetical trader Tom’s deltaneutral trading exercise (1) involved five trading days, with a break-even result, not including transaction costs. While Tom closed his position after five days, in a real situation, a speculator would have nearly daily decisions to make. Should the position be closed at breakeven,as it was in the example? The answer to this question is a subjective one that traders must make individually.

Just as trading market direction is an art, based on one’s instinct to enter trades and to take profits and losses, so too is deltaneutral trading more of an art than a science.Speculative Risks of Long Volatility:Speculators engaged in delta-neutral trading carry limited but substantial risk in the case of long volatility. For example, consider a deltaneutral position created by buying 50 call options and shorting 2,000 shares of stock.

Thus, if implied volatility were to drop by five percentage points without the underlying stock moving, then each option in this example would lose 60 cents per share, or $60 per option (5 percent volatility  $0.12 per share per 1 percent of volatility  100 shares per option  $60). For a long 50-option position, the loss would total $3,000 ($60 per option  50 options  $3,000), not including any loss from time decay.

And the loss would increase if implied volatility declined further. The maximum possible loss of a long volatility delta-neutral position occurs if the position is held to expiration and if the stock price equals the strike price of the options at expiration, in which case the options expire worthless.Speculative Risks of Short Volatility:The risk of delta-neutral trading borne by speculators is unlimited in the case of short volatility.

Delta-neutral positions with short options carry two risks. The first risk stems from rising implied volatility. If a speculator sells 100 Call options delta-neutral, and if each call has a vega of 0.09, or 9 cents per share, then the speculator will suffer a loss of $900 for each one percentage point rise in implied volatility.The second risk of delta-neutral positions with short options arises from a big move in the underlying stock. Table 8-10 shows how a sudden price rise from $42 to $49 in the underlying stock can cause a large loss for a delta-neutral position involving short options.

An announcement after the close of trading can cause a stock to open sharply higher or lower on the next day. Such price action at the start of trading is known as a gap opening and occurs frequently after earnings announcements. However, gaps in stock prices also can occur during the trading day. Traders with short option positions always must be on alert for such events.In Table 8-10, column 1 describes the initial position, and column 2 contains the initial prices.

The position is short 100 of the 45 Calls at 1.00 and long 3,000 shares of stock at $42.00. The name of the stock is omitted because it is unimportant. Row 3, column 2 indicates that the initial position is delta-neutral because the delta of each short call is 0.30.Column 3 reflects prices after the big move. The stock price has risen to $49.00, and the call price has risen to 4.90.

Column 4 contains the per-share loss of 3.90 for each option (row 1) and the pershare profit of $7.00 for the stock (row 2). Column 5 calculates the loss for the 100 Calls and the profit for the 3,000 shares. For the twopart position, the net loss is $18,000.The message of Table 8-10 is that having a delta-neutral position is not necessarily protection against losses.