Delta neutral is an options strategy in which you, the investor, take multiple positions with offsetting positive and negative deltas. With this strategy the overall delta of the assets totals zero.
Delta neutral strategy can be used to profit from implied volatility or from time decay of the options in your portfolio. Delta neutral strategies can also be used for hedging purposes.
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To better understand delta neutral, it might be worthwhile to quickly review some of the terms. An option, for example, is a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). If you are the person buying the option, you have the right to buy (call) a security (stock) at an agreed-upon price (the strike price) during a specific period.
Alternatively, as buyer, you have the right to sell (put) a security at an agreed-upon price during a certain period. Obviously, whether you are exercising a call or put determines whether you want the price of the underlying security to go up or down.
Delta is a ratio that compares the change in price of an option (for example) to the corresponding change in price of its derivative (the stock). If a stock option has a delta value of 0.65, if the underlying stock increases $1 per share, the option will rise by $0.65 per share.
Delta values can be positive or negative depending on whether the option is a call or put option. Call (buy) option deltas range from 0 to 1. Put (sell) option deltas range from -1 to 0.
Delta spread is how you establish the delta neutral position mentioned above. With this strategy you simultaneously buy and sell options in proportion to the neutral ratio. In other words, in such a way that the positive and negative deltas offset each other.
With a delta spread you could typically expect to make a small profit if the underlying security (stock) does not change widely in price. Larger gains (or losses) are possible if the stock moves significantly in either direction.
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How Delta Neutral Strategy Works
Suppose you have a 100 share stock position you believe will increase in price over the long term but you are worried that prices could go down in the short term. To counter this you decide to set up a delta neutral position. The delta of each share of your long-term position is 1. In this case your current position has a delta of positive 100 (delta times the number of shares).
To turn your position into one that is delta neutral, you need to enter a position with a total delta of negative 100. To do this locate at-the-money put (sell) options on the same stock trading at a delta of -0.5, you simply need to purchase 2 of these put options (100 shares each), which would generate a total delta of -100 (200 shares x -.05). The combination of your 100 shares with a delta of +100 and 2 (100 share) long at-the-money put options (at -0.5) with a delta of -100 gives you an overall position that is delta neutral.