Lesson Overview

Delta Hedging

Because delta is a measure of the responsiveness for an option position to the underlying stock, traders have been carried away for years with the concept of delta neutral trading as a way to generate income while staying completely nondirectional. And while we absolutely want to stay as neutral as possible I will help you understand why staying delta neutral all the time as a complete fantasy and unrealistic for retail traders. Plus, we'll show you how you can use beta to weight your deltas as a means to find appropriate hedges.

Show Video Transcript +

In this video tutorial, I want to talk about Delta hedging and really, the Delta hedging fantasy that I think is out there. Traders have been carried away for years with the concept of Delta neutral trading as a way to generate income while staying completely non-directional.

What we absolutely want to say is stay as neutral as possible. I want to help you understand why staying Delta neutral all the time is a complete fantasy and really unrealistic for retail traders like me and you.

First, here’s the thing. I get it. You want to be as neutral as possible and make money regardless of where the market moves. We can do that more or less, but we can’t always be 100% neutral to the market movement. It’s just impossible to do as a small retail trader.

Here's the setup. I want to go through an example here using a USO iron condor that we had recently put on. You can see here this is a snapshot of our account and on the left, you can see it’s a USO iron condor that we did in February.

We placed the trade back on December 29th, 2014, so you can see that's the exact date, and we’ll use that here in a little bit on the charts to use that date. But what's important here is that the circle on the right shows our new Deltas in the position.

Our overall Deltas in this trade is 11.7, so that means that we've got some positive Delta on this trade. But here's the thing. When we originally placed this trade, it was completely Delta neutral, meaning that we didn't care where USO went initially when we placed the trade because we were an even distance on either side of the market and completely neutral in our original Deltas.

But over time, the market has moved a little bit, USO has dropped a little bit, and this has created some more positive Delta in our portfolio than we originally want to.

Here's the setup. This red circle is when we originally traded USO back on 12/29. You can see USO was trading just above 20 at that point and our short strikes were at 25 and 16.

You can see our short strikes on this iron condor were evenly spaced apart, meaning we were 100% Delta neutral to begin with.

But as USO has started to trade lower and started to trade into the low teens, that means that our position is now more positive Delta and that really means that we need the market to rally a little bit in USO for us to get back to neutral.

That makes sense because it’s starting to test the lower boundary. If USO on the off chance had started to increase and started to test the higher boundary, then we’d actually start to see our Delta shift a little bit more negative because we need the stock to come back down to around 20 to re-neutralize the position.

Unless you have enough capital to continuously adjust… Because you can see even in just a few short weeks, our Deltas are now out of whack and not exactly neutral. But unless you have enough capital to adjust and neutralize your Deltas, it's an impossible task to accomplish this because Delta is fluid.

It’s always moving. It is not a stagnant indicator of how much money you’re going to make or lose. As the stock moves and as your position changes form as it gets closer to expiration or further from expiration, that Delta is going to move dramatically.

It’s impossible unless you’re constantly making adjustments to be Delta neutral. That said, we can use and have shown before that Beta weighting your positions and giving you some sort of adjusted Delta can help when you go to rebalance.

Even though we can’t be 100% Delta neutral, we can use Delta and Beta weighting to our favor and to our advantage when we go to make an adjustment. Here's a quick example of doing that.

With that same USO position that we were looking at, we went ahead and Beta weighted all of the iron condors that we currently have open and working. This is just at the time of the video.

We Beta weighted all of those Deltas to match USO. You can see the USO Delta stayed exactly the same at 11.7, but all of these other Deltas were Beta weighted and changed, so that they’re comparing themselves to USO.

Now you can see that compared to USO, we've actually got negative Deltas in our iron condor portfolio. It means that we’re a little bit long oil here and we actually need oil generally to maybe come down in most of these positions.

This gives us a good frame of reference here. If we want to re-neutralize this position, we’d actually go and try to look for a trade that gave us about 54 Deltas positive to re-neutralize this and get it to somewhere around zero if we want to be completely neutral.

That’s a really good example and hopefully this video proves to you that this whole idea of being Delta neutral while it really sounds great in textbooks and theory, it doesn't really work in the real world when it comes to retail trading an options trade.

As always, if you have any comments or questions, please ask them right below this video and this lesson. Until next time, happy trading!

Join 209,817 Options Traders

Membership is always FREE & you can upgrade anytime to unlock software tools.