Optionetics

Return to Article

Market Direction and Delta-Neutral Trading

Optionetics Staff

Professional options traders think in terms of spreads, and they hedge themselves to stay neutral on the market's direction. The direction of the underlying stock is less important to them than the volatility of the options (implied volatility) and the volatility of the underlying stock (statistical volatility).

These professional options traders also let the market tell them what to do. They recognize the market is saying that the appropriate strategy is to sell premium when option volatility is high. Conversely, they understand the market is saying that the low-risk strategy is to buy premium when implied volatility is low.

The most difficult aspect of delta-neutral options trading is learning to stay focused on volatility. The reason it's psychologically hard to trade on volatility considerations is because it's natural to look at a price chart, draw conclusions about future market direction, and be tempted to bias your positions in the direction you feel prices will move.

However, the point of neutral trading is that you want to make money based on how accurately you forecast volatility, and you don't want to run the risk of losing money by forecasting the market direction incorrectly. That's why you should initiate your spreads delta-neutral. It's also why you should adjust them back to neutral if they later become too long or short. This brings us to the second most difficult aspect of delta-neutral options trading: acting without hesitation when the market tells you to act.

If your position becomes too long or short, you must mechanically adjust without hoping for price to move in the direction of your delta bias. While it's natural to want to give the market a chance to go your way, the fact of the matter is that the market has already proven you wrong, so it would only be wishful thinking to expect it to suddenly move the way you want.

When you buy premium, be prepared to take action if the market makes a big move so you can lock-in profits. When you sell premium, don't expect volatility to collapse right away. You will probably need to be patient. You hope the underlying security won't move a lot while you're waiting. However, time decay helps you while you're waiting.

Don't expect huge profits on any neutral option spread. A properly implemented delta-neutral portfolio will result in some strikeouts, a lot of singles and an occasional double or triple. Just remember, you should hold positions only while volatility is out of line. You may need to adjust your position several times because it became delta long or short. However, you should close your positions when there's no edge remaining.

Finally, resist the desire to be a naked seller close to expiration. The rewards can be attractive because time decay rapidly accelerates the closer you get to expiration. However, there's no limit to the losses you could sustain if the market moves through the strike price of the short options and you don't quickly close or adjust your position.