 a  relatively  short  period  of  time.  Optimaltrades may combine futures with options, stocks with options, or optionswith  options  to  create  a  strategy  matrix.  This  matrix  combines  tradingstrategies to capitalize on a market going up, down, or sideways.
To locate proﬁtable trades, you need to understand how and when toapply the right options strategy. This doesn’t mean that you have to readthe most technically advanced books on options trading. You don’t needto be a genius to be a successful trader; you simply need to learn how tomake consistent proﬁts. One of the best ways to accomplish this task is topick one market and/or one trading technique and trade it over and overagain until you get really good at it. If you can ﬁnd just one strategy that
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works, you can make money over and over again until it’s so boring youjust have to move on to another one. After a few years of building up yourtrading experience, you will be in a position where you are constantlyredeﬁning your strategy matrix and markets.
Finding moneymaking delta neutral opportunities is not like seekingthe holy grail. Opportunities exist each and every day. It’s simply a matterof knowing what to look for. Speciﬁcally, you need to ﬁnd a market thathas  two  basic  characteristics—volatility  and  high  liquidity—and  use  theappropriate time frame for the trade.
THE DELTA
To become a delta neutral trader, it is essential to have a working under-standing of the Greek term delta and how it applies to options trading. Al-most all of my favorite option strategies use the calculation of the delta tohelp devise managed risk trades. The delta can be deﬁned as the change inthe option premium relative to the price movement in the underlying in-strument. This is, in essence, the ﬁrst derivative of the price function, forthose  of  you  who  have  studied  calculus.  Deltas  range  from  minus  1through zero to plus 1 for every share of stock represented. Thus, becausean option contract is based on 100 shares of stock, deltas are said to be“100” for the underlying stock, and will range from “–100” to “+100” for theassociated options.
A rough measurement of an option’s delta can be calculated by divid-ing the change in the premium by the change in the price of the underlyingasset. For example, if the change in the premium is 30 and the change inthe futures price is 100, you would have a delta of .30 (although to keep itsimple, traders tend to ignore the decimal point and refer to it as + or – 30deltas). Now, if your futures contract advances $10, a call option with adelta of 30 would increase only $3. Similarly, a call option with a delta of10 would increase in value approximately $1.
One  contract  of  futures  or  100  shares  of  stock  has  a  ﬁxed  delta  of100.  Hence,  buying  100  shares  of  stock  equals  +100  and  selling  100shares  of  stock  equals  –100  deltas.  In  contrast,  all  options  have  ad-justable deltas. Bullish option strategies have positive deltas; bearish op-tion  strategies  have  negative  deltas.  Bullish  strategies  include  longfutures or stocks, long calls, or short puts. These positions all have posi-tive deltas. Bearish strategies include short futures or stocks, short calls,or long puts; these have negative deltas. Table 6.1 summarizes the plusor minus delta possibilities.
As  a  rule  of  thumb,  the  deeper  in-the-money  your  option  is,  the
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TABLE 6.1 Positive and Negative Deltas
Market Up (Positive Deltas)
Market Down (Negative Deltas)
Buy calls.Sell puts.Buy stocks.Buy futures.
Sell calls.Buy puts.Sell stocks.Sell futures.
higher  the  delta.  Remember,  you  are  comparing  the  change  of  the  fu-tures or stock price to the premium of the option. In-the-money optionshave  higher  deltas.  A  deep  ITM  option  might  have  a  delta  of  80  orgreater. ATM options—these are the ones you will be probably workingwith the most in the beginning—have deltas of approximately 50. OTMoptions’  deltas  might  be  as  small  as  20  or  less.  Again,  depending  howdeep  in-the-money  or  out-of-the-money  your  options  are,  these  valueswill change. Think of it another way: Delta is equal to the probability ofan option being in-the-money at expiration. An option with a delta of 10has only a 10 percent probability of being ITM at expiration. That optionis probably also deep OTM.
When  an  option  is  very  deep  in-the-money,  it  will  start  acting  verymuch like a futures contract or a stock as the delta gets closer to plus orminus 100. The time value shrinks out of the option and it moves almostin  tandem  with  the  futures  contract  or  stock.  Many  of  you  might  havebought options and seen huge moves in the underlying asset’s price buthardly any movement in your option. When you see the huge move, youprobably think, “Yeah, this is going to be really good.” However, if youbought the option with a delta of approximately 20, even though the fu-tures or stock had a big move, your option is moving at only 20 percentof the rate of the futures in the beginning. This is one of the many rea-sons  that  knowing  an  option’s  delta  can  help  you  to  identify  proﬁtableopportunities.  In  addition,  there  are  a  number  of  excellent  computerprograms geared to assist traders to determine option deltas, includingthe Platinum site at Optionetics.com.
Obviously, you want to cover the cost of your premium. However, ifyou are really bullish on something, then there are times you need to stepup to the plate and go for it. Even if you are just moderately friendly tothe market, you still want to use deltas to determine your best trading op-portunity. Now, perhaps you would have said, “I am going to go for some-thing  a  little  further  out-of-the-money  so  that  I  can  purchase  moreoptions.”  Unless  the  market  makes  a  big  move,  chances  are  that  theseOTM  options  will  expire  worthless.  No  matter  what  circumstances  you
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encounter, determining the deltas and how they are going to act in differ-ent scenarios will foster proﬁtable decision making.
When I ﬁrst got into trading, I would pick market direction and thenbuy options based on this expected direction. Many times, they wouldn’tgo anywhere. I couldn’t understand how the markets were taking off butmy options were ticking up so slowly they eventually expired worthless.At that time, I had no knowledge of deltas. To avoid this scenario, remem-ber that knowing an option’s delta is essential to successful delta neutraltrading. In general, an option’s delta:
• Estimates the change in the option’s price relative to the underlyingsecurity. For example, an option with a delta of 50 will cost less thanan option with a delta of 80.
• Determines the number of options needed to equal one futures con-tract or 100 shares of stock to ultimately create a delta neutral tradewith an overall position delta of zero. For example, two ATM call op-tions  have  a  total  of  +100  deltas;  you  can  get  to  zero  by  selling  100shares of stock or one futures contract (–100 deltas).
• Determines the probability that an option will expire in-the-money. Anoption  with  50  deltas  has  a  50  percent  chance  of  expiring  in-the-money.
• Assists you in risk analysis. For example, when buying an option you
know your only risk is the premium paid for the option.
To  review  the  delta  neutral  basics:  The  delta  is  the  term  used  bytraders to measure the price change of an option relative to a change inprice  of  the  underlying  security.  In  other  words,  the  underlying  securitywill make its move either to the upside or to the downside. A tick is theminimum price movement of a particular market. With each tick change, arelative change in the option delta occurs. Therefore, if the delta is tied tothe change in price of the underlying security, then the underlying securityis said to have a value of 1 delta. However, I prefer to use a value of 100deltas  instead  because  with  an  option  based  on  100  shares  of  stock  it’seasier to work with.
Let’s create an example using IBM options, with IBM currently trading
at $87.50.
• Long 100 shares of IBM = +100 deltas.• Short 100 shares of IBM = –100 deltas.
Simple math shows us that going long 200 shares equals +200 deltas,going long 300 shares equals +300 deltas, going short 10 futures contractsequals –1,000 deltas, and so on. On the other hand, the typical option has a
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delta of less than 100 unless the option is so deep in-the-money that it actsexactly like a futures contract. I rarely deal with options that are deep in-the-money as they generally cost too much and are illiquid.
All options have a delta relative to the 100 deltas of the underlying se-curity. Since 100 shares of stock are equal to 100 deltas, all options musthave  delta  values  of  less  than  100.  An  Option  Delta  Values  chart  can  befound in Appendix B outlining the approximate delta values of ATM, ITM,and OTM options.
VOLATILITY
Volatility  measures  market  movement  or  nonmovement.  It  is  deﬁned  asthe magnitude by which an underlying asset is expected to ﬂuctuate in agiven period of time. As previously discussed, it is a major contributor tothe price (premium) of an option; usually, the higher an asset’s volatility,the higher the price of its options. This is because a more volatile asset of-fers  larger  swings  upward  or  downward  in  price  in  shorter  time  spansthan  less  volatile  assets.  These  movements  are  attractive  to  optionstraders  who  are  always  looking  for  big  directional  swings  to  make  theircontracts proﬁtable. High or low volatility gives traders a signal as to thetype of strategy that can best be implemented to optimize proﬁts in a spe-ciﬁc market.
I  like  looking  for  wild  markets.  I  like  the  stuff  that  moves,  the  stuffthat  scares  everybody.  Basically,  I  look  for  volatility.  When  a  market  isvolatile, everyone in the market is confused. No one really knows what’sgoing on or what’s going to happen next. Everyone has a different opinion.That’s when the market is ripe for delta neutral strategies to reap major re-wards. The more markets move, the more proﬁts can potentially be made.Volatility in the markets certainly doesn’t keep me up at night. For themost  part,  I  go  to  bed  and  sleep  very  well.  Perhaps  the  only  problem  Ihave as a 24-hour trader is waking up in the middle of the night to sneak apeek at my computer. If I discover I’m making lots of money, I may stay upthe rest of the night to watch my trade.
As uncertainty in the marketplace increases, the price for options usu-ally  increases  as  well.  Recently,  we  have  seen  that  these  moves  can  bequite dramatic. Reviewing the concept of volatility and its effect on optionprices is an important lesson for beginning and novice traders alike. Basi-cally, an option can be thought of as an insurance policy—when the likeli-hood of the “insured” event increases, the cost or premium of the policygoes  up  and  the  writers  of  the  policies  need  to  be  compensated  for  thehigher  risk.  For  example,  earthquake  insurance  is  higher  in  Californiathan in Illinois. So when uncertainty in an underlying asset increases (as
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we  have  seen  recently  in  the  stock  market),  the  demand  for  options  in-creases as well. This increase in demand is reﬂected in higher premiums.When we discuss volatility, we must be clear as to what we’re talkingabout. If a trader derives a theoretical value for an option using a pricingmodel  such  as  Black-Scholes,  a  critical  input  is  the  assumption  of  howvolatile the underlying asset will be over the life of the option. This volatil-ity assumption may be based on historical data or other factors or analy-ses. Floor and theoretical traders spend a lot of money to make sure thevolatility input used in their price models is as accurate as possible. Thevalidity  of  the  option  prices  generated  is  very  much  determined  by  thistheoretical volatility assumption.
Whereas  theoretical  volatility  is  the  input  used  in  calculating  optionprices,  implied  volatility  is  the  actual  measured  volatility  trading  in  themarket. This is the price level at which options may be bought or sold. Im-plied volatilities can be acquired in several ways. One way would be to goto a pricing model and plug in current option prices and solve for volatil-ity, as most professional traders do. Another way would be to simply golook it up in a published source, such as the Optionetics Platinum site.
Once you understand how volatilities are behaving and what your as-sumptions might be, you can begin to formulate trading strategies to capi-talize  on  the  market  environment.  However,  you  must  be  aware  of  thecharacteristics  of  how  volatility  affects  various  options.  Changes  involatility affect at-the-money option prices the most because ATM optionshave the greatest amount of extrinsic value or time premium—the portionof the option price most affected by volatility. Another way to think of it isthat  at-the-money  options  represent  the  most  uncertainty  as  to  whetherthe option will ﬁnish in-the-money or out-of-the-money. Additional volatil-ity in the marketplace just adds to that.
Generally  changes  in  volatility  are  more  pronounced  in  the  frontmonths than in the distant months. This is probably due to greater liquid-ity and open interest in the front months. However, since the back monthoptions have more time value than front month options, a smaller volatil-ity  change  in  the  back  month  might  produce  a  greater  change  in  optionprice  compared  to  the  front  month.  For  example,  assume  the  following(August is the front month):
• August 50 calls (at-the-money) = $3.00; Volatility = 40%• November 50 calls (at-the-money) = $5.00; Volatility = 30%
Following an event that causes volatility to increase we might see:
• August 50 calls = $4.00; Volatility = 50%• November 50 calls = $6.50; Volatility = 38%
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We can see that even though the volatility increased more in August,the November options actually had a greater price increase. This is due tothe greater amount of time premium or extrinsic value in the Novemberoptions.  Care  must  be  taken  when  formulating  trading  strategies  to  beaware of these relationships. For example, it is conceivable that a spreadcould  capture  the  volatility  move  correctly,  but  still  lose  money  on  theprice changes for the options.
Changes in volatility may also affect the skew: the price relationshipbetween options in any given month. This means that if volatility goes upin the market, different strikes in any given month may react differently.For example, out-of-the-money puts may get bid to a much higher relativevolatility than at-the-money puts. This is because money managers and in-vestors prefer to buy the less costly option as disaster protection. A $2 putis  still  cheaper  than  a  $5  put  even  though  the  volatility  might  be  signiﬁ-cantly higher.
So how does a trader best utilize volatility effects in his/her trading?First, it is important to know how a stock trades. Events such as earningsand  news  events  may  affect  even  similar  stocks  in  different  ways.  Thisknowledge can then be used to determine how the options might behaveduring  certain  times.  Looking  at  volatility  graphs  is  a  good  way  to  get  afeel for where the volatility normally trades and the high and low ends ofthe range.
A sound strategy and calculated methodology are critical to an optiontrader’s success. Why is the trade being implemented? Are volatilities lowand do they look like they could rally? Remember that implied volatility isthe  market’s  perception  of  the  future  variance  of  the  underlying  asset.Low volatility could mean a very ﬂat market for the foreseeable future. If apricing model is being used to generate theoretical values, do the marketvolatilities look too high or low? If so, be sure all the inputs are correct.
The market represents the collective intelligence of the option play-ers’  universe.  Be  careful  betting  against  smart  money.  Watch  the  orderﬂow if possible to see who is buying and selling against the market mak-ers. Check open interest to get some indication of the potential action, es-pecially if the market moves signiﬁcantly. By keeping these things in mindand managing risk closely, you will increase your odds of trading successdramatically.
RELATIONSHIP BETWEEN VOLATILITY AND DELTA
One of the concepts that seems to confuse new options traders is the rela-tionship between volatility and delta. First, let’s quickly review each topicseparately. Volatility represents the level of uncertainty in the market and
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the degree to which the prices of the underlying are expected to changeover time. When there is more uncertainty or fear, people will pay morefor options as a risk control instrument. So when the markets churn, in-vestors get fearful and bid up the prices of options. As people feel moresecure  in  the  future,  they  will  sell  their  options,  causing  the  impliedvolatility to drop.
Delta can be thought of as the sensitivity of an option to movement inthe  underlying  asset.  For  example,  an  option  with  a  delta  of  50  meansthat for every $1 move in the underlying stock the option will move $0.50.Options  that  are  more  in-the-money  have  higher  deltas,  as  they  tend  tomove in a closer magnitude with the stock. Delta can also be thought ofas  the  probability  of  an  option  ﬁnishing  in-the-money  at  expiration.  Anoption  with  a  delta  of  25  has  a  25  percent  chance  of  ﬁnishing  in-the-money at expiration.
An increase in volatility causes all option deltas to move toward 50.So  for  in-the-money  options,  the  delta  will  decrease;  and  for  out-of-the-money  options,  the  delta  will  increase.  This  makes  intuitive  sense,  forwhen  uncertainty  increases  it  becomes  less  clear  where  the  underlyingmight end up at expiration. Since delta can also be deﬁned as the proba-bility of an option ﬁnishing in-the-money at expiration, as uncertainty in-creases,  all  probabilities  or  deltas  should  move  toward  50–50.  Forexample,  an  in-the-money  call  with  a  delta  of  80  under  normal  volatilityconditions might drop to 65 under a higher-volatility environment, reﬂect-ing less certainty that the call will ﬁnish in-the-money. Thus, by expiration,volatility is zero since we certainly know where the underlying will ﬁnish.At  zero  volatility,  all  deltas  are  either  0  or  1,  ﬁnishing  either  out-of-the-money or in-the-money. Any increase in volatility causes probabilities tomove away from 0 and 1, reﬂecting a higher level of uncertainty.
It is always important to track volatility, not only for at-the-money op-tions  but  also  for  the  wings  (out-of-the-money)  options  as  well.  A  trademay  have  a  particular  set  of  characteristics  at  one  volatility  level  but  acompletely different set at another. A position may look long during a rallybut  once  volatility  is  reset,  it  may  be  ﬂat  or  even  short.  Knowing  howdeltas behave due to changes in volatility and movement in the underlyingis essential for proﬁtable options trading.
APPROPRIATE TIME FRAME
The next step is to select the appropriate time frame for the kind of tradeyou want to place. Since I am no longer a day trader, I’m usually in the 30-to 90-day range of trading. And for the most part, I prefer 90 days. Since I
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don’t want to sit in front of a computer all day long at this point in my trad-ing career, I prefer to use delta neutral strategies. They allow me to createtrades with any kind of time frame I choose.
Delta neutral strategies are simply not suitable for day trading. In fact,day trading doesn’t work in the long run unless you have the time and theinclination to sit in front of a computer all day long. Day trading takes aspeciﬁc kind of trader with a certain kind of personality to make it work.My trading strategies are geared for a longer-term approach.
If you’re going to go into any business, you have to size up the compe-tition.  In  my  style  of  longer-term  trading,  my  competition  is  the  ﬂoortrader who makes money on a tick-by-tick basis. But I choose not to playthat  game.  I’ve  taken  the  time  frame  of  a  ﬂoor  trader—which  is  tick-by-tick—and expanded it to a period ﬂoor traders usually don’t monitor. Ap-plying my strategies in longer time frames than day-to-day trading is myway of creating a trader’s competitive edge.
CONCLUSION
Delta neutral trading combines options with stocks (or futures) and op-tions with options to create trades with an overall position delta of zero.To set up a balanced delta neutral trade, it is essential to become famil-iar with the delta values of ATM, ITM, and OTM options. Deltas provide ascientiﬁc formula for setting up trading strategies that give you a com-petitive edge over directional traders. Experience will teach you how touse  this  approach  to  take  advantage  of  various  market  opportunitieswhile  managing  the  overall  risk  of  the  trade  efﬁciently.  I  cannot  stressenough the importance of developing a working knowledge of the deltasof options.
Professional options traders think in terms of spreads and they hedgethemselves to stay neutral on market direction. The direction of the un-derlying stock is less important to them than the volatility of the options(implied volatility) and the volatility of the underlying stock (statistical orhistorical volatility).
Professional options traders also let the market tell them what to do.They recognize the market is saying that the appropriate strategy is to sellpremium  when  option  volatility  is  high  (options  are  expensive).  Con-versely, they understand the market is saying that the low-risk strategy isto buy premium when implied volatility is low (options are cheap).
The most difﬁcult aspect of delta neutral options trading is learning tostay focused on volatility. The reason it’s psychologically hard to trade onvolatility  considerations  is  because  it’s  natural  to  look  at  a  price  chart,
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draw conclusions about future market direction, and be tempted to biasyour positions in the direction you feel prices will move.
However, the point of delta neutral trading is that you want to makemoney based on how accurately you forecast volatility; you don’t want torun  the  risk  of  losing  money  by  forecasting  market  direction  incorrectly.That’s why you should initiate your spreads delta neutral. It’s also why youshould adjust them back to neutral if they later become too long or short—which brings us to the second most difﬁcult aspect of delta neutral optionstrading: acting without hesitation when the market tells you to act.
If your position becomes too long or short, you must mechanically ad-just it without hoping for the price to move in the direction of your deltabias. 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, soit would only be wishful thinking to expect it will suddenly move the wayyou want. Every delta neutral trader knows the feeling of having a weightlifted from his shoulders the moment he or she does the right thing byexecuting an adjustment to get neutral.
When  you  buy  premium,  be  prepared  to  take  action  if  the  marketmakes a big move so you can lock in proﬁts. When you sell premium, don’texpect volatility to collapse right away. You will probably need to be pa-tient. You hope the underlying asset won’t move a lot while you’re waiting.However, time decay helps you while you’re waiting.
As  you  can  see,  the  concept  of  delta  neutral  is  not  one  trade,  butrather  a  method  of  advanced  thinking.  If  you  can  master  the  basics  ofdelta neutral thinking, then you can create delta neutral trades from anycombination of assets. The concept is to be able to make a proﬁt regard-less of where the stock moves.
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TheOtherGreeks
T o create a delta neutral trade, you need to select a calculated ratio
of short and long positions that combine to create an overall posi-tion delta of zero. To accomplish this goal, it is helpful to review avariety of risk exposure measurements. The option Greeks are a set ofmeasurements that can be used to explore the risk exposures of speciﬁctrades.  Since  options  and  other  trading  instruments  have  a  variety  ofrisk exposures that can vary dramatically over time or as markets move,it is essential to understand the various risks associated with each tradeyou place.
DEFINING THE GREEKS
Options traders have a multitude of different ways to make money by trad-ing options. Traders can proﬁt when a stock price moves substantially ortrades in a range. They can also make or lose money when implied volatil-ity increases or decreases. To assess the advantage that one spread mighthave over another, it is vital to consider the risks involved in each spread.When making these kinds of assessments, options traders typically refer tothe  following  risk  measurements:  delta,  gamma,  theta,  and  vega.  Thesefour elements of options risk are referred to as the option “Greeks.” Let’stake a deeper look at the most commonly used Greeks and how they canbe used in options trading.
First, I would like to go over a couple of technical issues in regard to
175
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the Greeks. These numbers are calculated using higher-level mathematicsand the Black-Scholes option pricing model. My objective is not to explainthose computations, but to shed some light on the practical uses of theseconcepts.  Additionally,  I  would  suggest  using  an  options  software  pro-gram to calculate these numbers so that you are not wasting precious timeon tedious mathematics. Lastly, it is important to realize that these num-bers  are  strictly  theoretical,  meaning  that  model  values  may  not  be  thesame as those calculated in real-world situations.
Each risk measurement (except vega) is named after a different let-ter in the Greek alphabet—delta, gamma, and theta. In the beginning, itis  important  to  be  aware  of  all  of  the  Greeks,  although  understandingthe delta is the most crucial to your success. Comprehending the deﬁni-tion  of  each  of  the  Greeks  will  give  you  the  tools  to  decipher  optionpricing as well as risk. Each of the terms has its own speciﬁc use in day-to-day trading by most professional traders as well