From the March 01, 2010 issue of Futures Magazine • Subscribe!

Using options to get back to delta neutral

In a recent Options Strategy, (January 2010), we explained the fundamentals of gamma scalping. Some of our readers told us that the cost of the use of stock to hedge a long gamma position was prohibitive for the average Joe. We acknowledge that many traders are constrained by capital limitations, but for every trading dilemma, there is a solution.

A long gamma position is one where a trader is long calls, puts, or both (such as a straddle) and wants to trade a stock around the change in deltas. Doing this helps to capture daily profits, so you can offset the time decay of the options position. Options are wonderful because they can be utilized to take the place of a long or short stock that is cheaper than an actual stock position.

As a refresher, we will start under the assumption that Apple (AAPL) is going to make a large move in a certain direction; however, we cannot tell if it is going to fail at resistance at the previous highs, or if the stock is going to blast off to the stratosphere. With this direction of uncertainty, a straddle can be an excellent way of playing both sides of the market. With the stock at approximately $200, we will use the 200 call and the 200 put as a learning tool.

In our example, the stock ran up to $210 per share. When the trader owns a straddle, he wants the stock to move in either direction in a big way. Unfortunately, the stock may often go back to the original starting point after the move and all the effort will have been wasted. Since the stock’s move to $210 will force a change in the option’s deltas (because of a Greek called gamma), we could use this change in deltas to adjust the position. By returning our position to delta neutral, we could profit from a potential stock collapse while locking in some of this movement as potential profit.

In the previous example, when the call delta had changed from +50 to +70 and the put delta moved from -50 to -30, it changed the overall delta on the straddle to 400, compelling us to sell 400 shares of stock to get back to an overall delta neutral position.

However, because many people would be constrained by the cost of selling 400 shares of Apple, we will illustrate how one can use options in lieu of a stock.

There are two ways to proceed from here:

One, you can add to the position. If you still believe that the underlying stock is capable of making large moves and you have enough capital left to invest, you can add to the position by getting short deltas. You could either buy puts or put spreads.

With this step, you can buy any put or put spread. Typically, a trader will either purchase more of the original 200 puts, or go to the at-the-money (ATM) 210 put, now that the stock is higher. For our tutorial, we will determine how many of the 210 puts we need to buy to get enough short deltas to become delta neutral again.

Because the 210 puts are ATM options, they are short 50 deltas per contract purchased (or long 50 deltas if we sold them) by definition. Being long 400 deltas requires us to get long eight ATM puts (400 deltas / -50 deltas = eight contracts). “Adding to a winner” shows what the resulting position would look like.

You also can subtract from the position. If you believe the stock is going to move less or if you want to take some money off of the table, you can close out some of the original position at this point (see “Taking profits”). Because we are long the 200 calls, which currently are 70 long deltas a piece, we can sell five or six of them to get closer to delta neutral (70 deltas x six calls = 420 short deltas). As you can see from this discussion, options provide alternatives to stock scenarios even when implementing option strategies like gamma scalping.

Alex Mendoza is the chief options strategist with Random Walk, which has produced numerous articles, books and CDs on options trading, including a book on broken-wing butterfly spreads. Visit their Web site:

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