Risk management is one of primary habits of a professional option trader. To be able to identify the risk and manage it is a primary task. The four risks are commonly called the "greeks" , although a common name for one of them is not a greek letter. OptimalTrader has a tool called the Ratio Finder which will aid you in speeding up the task of finding the correct quantity of options to make a neutral trade.
Delta Neutral
The name of this web site is of course, www.deltaneutral.com. Of course we discuss a lot more than just delta neutral trading, but that was the best name available at the time this web site was created. Delta neutral trading is probably the most common of the four.
When most people think of a delta neutral trade, they usually are thinking of a trade in which they can create in which they make money if the stock either up or down. The typical "smiley face" straddle trade, or strangle trade. And as the stock moves rapidly back and forth, the trade is adjusted to bring it back to delta neutrality, the goal being to capture profits. This is also called "gamma scalping".
The straddle trade is a positive gamma trade, but there are also negative gamma trades which can also be consider delta neutral trades such as the short strangle and short straddle. With the negative gamma delta neutral trades, you are trying to make a profit by earning the time premium.
Let's illustrate a long gamma trade, a straddle using OptimalTrader. Launch OptimalTrader and go to the Chain page (as we have done in prior lessons) to build a trade. Enter in QQQQ as the symbol and view the option chain.
On the date of this writing, QQQQ was trading at 36.65. So build a trade with 100 37 calls expiring about 43 days out, and 100 37 puts with the same expiration date. Copy this trade to the Risk Graph.
This has created a trade with a net delta of -363.8. We have three ways to adjust this. With calls, puts, or stock. Also we could combine these to become delta neutral. The most precise way would be to buy 364 shares of stock. That is easy to calculate. But what if we wanted to use calls to make our adjustment? We would have to calculate the proper number of calls. The quicker way is to use OptimalTrader's Ratio Finder tool.
From the Tools menu, select Ratio Finder. In the first drop down, select the row with our calls in it. Then in the second drop down select Position Delta. Leave the default value to zero in the text box and click the button.
This added 8 call options to our trade and our trade is a near delta neutral as possible with using our original options. There are other ways to do this with calls, by adding different strikes such as the 36 strike or 38 strike.
Using this same method, we could have bought 93 puts instead of 100 puts to go with our 100 calls.
If we had a short straddle using the same options, we could sell 93 puts and sell 100 calls to make this a short gamma delta neutral trade.
Gamma Neutral
The easiest gamma neutral trade is to just buy 100 shares of stock. Only calls and puts have gamma. If we use our same example as before, and using the Ratio Tool, we find that if we select Position Gamma to be equal to zero, then selling 95 calls and buying 100 puts would do the trick. We have synthetic short stock. This is probably not what you want.
A more interesting concept would be to make the gamma neutral AND the delta neutral at the same time. If you notice with the first example, we had a gamma of 2.6 and a delta of -9,731. How can we make this delta neutral? The only thing we have that has no gamma is stock. So what if we buy 9,731 shares of stock at the same time? We have a straight line at the expiration. So if we had a trade that we legged into, we could lock in our profits so that no matter where the stock ended, we would have a constant profit.
Vega Neutral and Theta Neutral
Vega neutral and theta neutral trades follow a similar pattern. Options with positive gamma have negative theta and positive vega. Theta is time decay and vega measures the sensitivity to implied volatility changes. The more interesting of the two is vega neutral. So you will need to combine options that you purchase (which have positive vega) with options that you sell (which have negative vega)
Using the Chain page to build a trade, this time a call butterfly, we are buying 100 options in each of the wings, and then selling 200 calls in the body. We then use the Ratio Finder to adjust the body so that the trade is Vega neutral. In our example, the trade ends up being 100 long 33 calls, 145 short 36 calls, and 100 long 39 calls. It makes an interesting trade, but we are positive 2430 deltas. If we are bullish, then we can leave this as it is. Or we can short the stock by 2,430 shares to create a vega neutral, gamma neutral trade.
Conclusion
In this lesson we learned how to use the Ratio Finder. We also briefly discuss synthetic stock, and how to lock in profits by creating a gamma-delta neutral trade.
End of Lesson 6