Options Trading: Delta Hedging for a Choppy Market

Posted On May 31, 2018 2:00 pm

The market, and many individual stocks that comprise it, have moved into a choppy trading range. So, I’m taking a look at utilizing some delta-neutral options trading strategies.

Delta-neutral options trading is essentially volatility trading.  In a short volatility example, traders want to maximize their time decay whilst simultaneously delta hedging to keep their directional exposure in check. By doing this, the Greeks, theta and vega become the big drivers in the position rather than delta.

One of my favorite delta-neutral strategies is the short straddle. These typically start delta-neutral, or close to it, but as the underlying stock moves, the position starts to pick up either positive or negative delta.

If the stock rallies, the short straddle will show negative delta (i.e. the traders wants the stock to fall back into the straddle zone). Conversely, if the stock falls, the short straddle will show positive delta (the trade wants the stock to rise back up).

Using stock buys and sells to hedge the delta allows us to focus on the aforementioned vega and theta. There are two choices on how to delta hedge:

  • When a certain delta level has been reached
  • After a certain period of time has passed.

Typically, I tend to prefer to hedge my delta-neutral options trading via method 1. However, in this example, I chose to delta hedge once per week. I’ll walk you through the exact trades shortly.

I like to search for really beaten-down stocks, either to find some value for a long-term play, or else to take advantage of the high implied volatility.

One such trade that jumped out recently was on Philip Morris (PM) .

In late April, the company had a disastrous earnings announcement and dropped around 15% on the day. These sorts of drops provide massive opportunities for option traders. You can see the drop in the chart below. I’ve seen this pattern so many times in the last few years – a huge drop and then sideways to slightly lower over the next few weeks.

Tobacco is a dying industry, and not one that I want to invest in, so I decided to try a pure volatility play by entering a delta-neutral short straddle with weekly hedging.

Below you can see the spike in implied volatility after the drop, to the highest level in 12 months. That’s a great time to get short volatility.

I decided to do a short straddle, but also to hedge out the delta as the stock moved. I would neutralize it every week on Wednesday, rather than at a pre-defined level. Here are the details:

  • Sell 2 June 15th, 2018 82.50 Put @ $2.96.      IV = 22.22%
  • Sell 2 June 15th, 2018 82.50 Call @ $2.55.     IV = 22.22%
  • Net Credit:$ 1,102

Here’s what the payoff diagram looked like. At trade initiation, you can tell much difference between this delta-hedged trade and a regular short straddle.

At this point we have positive delta because we want the stock to rally back up to the middle of the straddle.

From here, I could leave the trade as is, or get back to delta neutral, or I with two weeks to go could just hedge some of the delta.

I’ll keep you posted as to how it works out.

 Related: This is a Risky Part of the Business Cycle – Here’s How to Protect Your Portfolio. 

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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