how delta neutral works
a positive delta means the option s price will increase when the stock price increases and decrease when the stock price decreases conversely a negative delta means the option s price will decrease as the stock price increases and increase when the stock price decreases let s get some more terms out of the way before laying out this strategy we can now move through how a delta neutral strategy getting a delta of zero would work suppose you have a long position in a stock delta of 1 to make this position delta neutral you could buy a put option on the same stock with a delta range from 1 to 0 this behavior is seen with deep in the money call options if the stock s price increases by 1 the long position will gain 1 because of the 1 delta however the price of the put option will decrease offsetting the gain from the long position this ensures that the portfolio s overall value remains unchanged despite the stock s change in price likewise if an option has a delta of zero and the stock increases by 1 the option s price won t increase at all a behavior seen with deep out of the money call options if an option has a delta of 0 5 its price will increase by 0 50 for every 1 increase in the underlying stock this is because the delta 0 5 is multiplied by the change in the stock s price 1 resulting in a 0 50 change in the option s price suppose you have a stock position of 200 shares of company x trading at 100 per share that you believe will increase in price over the long term you are worried though that prices could drop in the short term so you decide to set up a delta neutral position to hedge this directional risk being long 200 shares of stock means that your delta is 200 you can find options contracts providing the opposite delta exposure to cancel that out i e 200 say that you find an at the money put option on company x with a delta of 0 50 the sign is negative because put options gain value as the underlying price declines and lose value when it rises options on stocks represent 100 shares of the underlying asset so buying one company x put would provide you with the following 0 50 100 50 deltas if you bought four of these put options you would have a total delta as follows 400 0 5 200 with the combined position of 200 company x shares and long 4 at the money put options on company x your overall position would not be zero i e delta neutral while an initial delta hedge can set up a neutral position as the underlying stock moves the delta of the options used will also change this is known as the option s gamma as a result traders who want to maintain delta neutrality need to monitor and adjust their positions to reestablish canceling deltas this process is known as dynamic hedging pros and cons of delta neutral positionshedges against small price movements in either directionallows options traders to focus on nondirectional strategiesflexibility in establishing delta neutral positionslarge sudden moves can produce directional exposure because of gammacan be costly and time consuming to monitor and adjustthe primary benefit of a delta neutral position is that it s immune to small changes in the price of the underlying asset either up or down this strategy is about betting on the direction in which the stock price will move and not about having to worry about minor fluctuations in price delta neutral traders often seek to profit from options time decay represented by the greek theta or changes in implied volatility the greek vega and not the directional movements in the stock since delta neutrality focuses on offsetting price movement risks traders can focus on these other factors affecting the option s value however being delta neutral also means missing out on those price movements so it does present a sort of opportunity cost for some traders even if you are not concerned about these price changes maintaining a delta neutral position as the underlying moves requires active monitoring and adjusting which can be costly and not well suited for inexperienced traders in addition large unexpected market moves can lead to substantial losses since the position is neutral only to small price movements so significant and sudden market events can undo the strategy 