Delta neutral strategy
A delta neutral strategy is an investment strategy involving offsetting long and short positions in two different forms of an underlying asset. It is designed to reduce the exposure of the portfolio to changes in the price of the underlying asset. This strategy involves offsetting the price movements of an underlying asset with the use of derivatives, such as options and futures contracts. By doing so, investors are able to reduce the risk of their portfolio, while still benefiting from the potential upside of the underlying asset.
Example of delta neutral strategy
- A trader may use a delta neutral strategy to reduce the risk of their portfolio when trading a stock. For example, the trader may buy a call option on a stock and sell a put option on the same stock. This will create a position that is delta neutral as the delta of the call option will be offset by the delta of the put option. This type of strategy allows the trader to benefit from the upside of the stock while limiting their downside risk.
- Another example of a delta neutral strategy is a straddle. In this strategy, an investor will buy a call and put option on the same stock with the same strike price and expiration date. This creates a position that is delta neutral as the delta of the call and put options will offset each other. This allows the investor to benefit from the potential upside or downside of the stock without having to take a directional position.
- A third example of a delta neutral strategy is a covered call. In this strategy, an investor will buy a stock and then sell a call option on the same stock. This creates a position that is delta neutral as the delta of the call option will be offset by the delta of the stock. This allows the investor to benefit from the upside of the stock while also collecting the premium from selling the call option.
When to use delta neutral strategy
A delta neutral strategy can be used in a variety of situations. It is often used by investors with a medium - to long-term outlook who want to reduce their exposure to price movements in the underlying asset. It is also used by those who want to take advantage of the potential for profits from price changes in the underlying asset without taking on too much risk. Some of the applications of a delta neutral strategy include:
- Hedging against potential losses from price movements in the underlying asset: By taking offsetting positions in two different forms of the underlying asset, investors can protect themselves against losses due to price movements.
- Taking advantage of potential price movements in the underlying asset: By taking offsetting positions in two different forms of the underlying asset, investors can benefit from potential price movements without taking on too much risk.
- Speculating on potential price movements in the underlying asset: By taking offsetting positions in two different forms of the underlying asset, investors can speculate on potential price movements without taking on too much risk.
- Mitigating portfolio risk: By taking offsetting positions in two different forms of the underlying asset, investors can diversify their portfolio and reduce overall risk.
Types of delta neutral strategy
A delta neutral strategy is an investment strategy involving offsetting long and short positions in two different forms of an underlying asset. It is designed to reduce the exposure of the portfolio to changes in the price of the underlying asset. The following are some of the main types of delta neutral strategies:
- Long-Short Equity Strategy: This strategy involves taking long and short positions in the same underlying asset, with the goal of offsetting the price movements of the asset.
- Covered Call Strategy: This strategy involves writing a call option and investing in the underlying asset. The goal of this strategy is to generate income through the sale of the call option while also limiting the downside risk.
- Long-Short Futures Strategy: This strategy involves taking a long position in a futures contract and a short position in another futures contract. The goal is to hedge against the price movements of both futures contracts.
- Options Collar Strategy: This strategy involves taking a long position in a put option and a short position in a call option on the same underlying asset. The goal is to protect against potential losses from the underlying asset while also receiving income from the sale of the call option.
Steps of delta neutral strategy
A delta neutral strategy involves the following steps:
- Identify the underlying asset you wish to invest in.
- Determine the risk/reward profile of the asset, and the type of derivatives that can be used to offset the price movements of the asset.
- Calculate the delta of the derivatives and the underlying asset to ensure that the strategies are offsetting each other.
- Execute the trades in the correct amounts to ensure that the delta is neutral.
- Monitor the delta of the positions and adjust accordingly to remain delta neutral.
- Rebalance the portfolio as needed to maintain the desired delta neutral strategy.
Limitations of delta neutral strategy
A delta neutral strategy can be an effective way to reduce risk in an investment portfolio; however, there are some limitations to consider. These include:
- Delta neutrality does not guarantee a completely risk-free investment; it merely reduces the potential for loss.
- Delta neutral strategies require investors to be knowledgeable about derivatives and their associated risks. As such, they may be best suited for more experienced investors.
- Delta neutral strategies can be complex and time consuming to execute.
- Delta neutral strategies may not always provide the desired level of risk reduction, as the underlying asset may still be subject to wide price swings.
- Delta neutral strategies may be more expensive to maintain than other investment strategies, due to the costs associated with using derivatives.
A delta neutral strategy is an investment approach that involves offsetting long and short positions in two different forms of an underlying asset. It is designed to reduce the exposure of the portfolio to changes in the price of the underlying asset. Other approaches related to this strategy include:
- Arbitrage - Arbitrage is a trading strategy that seeks to exploit differences in prices among different markets. It involves buying and selling assets with the intention of profiting from price discrepancies.
- Hedging - Hedging is a risk management strategy that aims to reduce the risk of an investment by protecting it from adverse price movements. Hedging typically involves taking offsetting positions in different markets or financial instruments.
- Pair Trading - Pair trading is another strategy that involves taking offsetting positions in two different stocks. It is designed to profit from the relative performance of the two stocks, while limiting losses if one of the stocks declines in price.
In summary, delta neutral strategies involve offsetting long and short positions in two different forms of an underlying asset in order to reduce exposure to price movements. Other related approaches include arbitrage, hedging, and pair trading.
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References
- Bartels, H. J., & Lu, J. (2000). Volatility forecasting and delta-neutral volatility trading for Dtb options on the Dax. Proceedings AFIR, 51-66.
- Schmitt, C., & Kaehler, J. (1996). Delta-neutral volatility trading with intra-day prices: an application to options on the dax (No. 96-25). ZEW Discussion Papers.