Why Delta Matters

The key to a truly market-neutral trading strategy is to keep your positions delta-neutral. If you’re not familiar with “the Greeks”, that’s okay:

Delta measures the sensitivity of an option’s theoretical value to a change in the price of the underlying asset. It is represented as a number between minus one and one, and it indicates how much the value of an option should change when the price of the underlying stock rises by one dollar.

Remember, the idea behind the iron condor is to position ourselves so that we make money no matter which direction the market moves. Well, sometimes the market moves a long way in one direction, threatening to violate the outer bounds of our position. In those kinds of situations, the side of the trade that is close to being violated will move in price much more dramatically than will the other side of the trade. The reason one side of a trade sometimes changes in price more dramatically than the other side is that the delta of the fast-moving side is higher. So to keep our trade truly market-neutral, we have to keep it delta-neutral. An example will show you what we mean.

Examine this hypothetical trade: with SPY at 144 and 4+ weeks until expiration, let’s say we put on the following trade. The prices and credit received don’t really matter for this example.

+1 SPY 148 call
-1 SPY 146 call
-1 SPY 142 put
+1 SPY 140 put

In the first several days of the life of this trade, any move in the underlying should be pretty evenly reflected in the two sides of the trade. So if the index moves down to 143.70 a few days after we opened the trade, our puts should increase in value by nearly the same amount that our calls decrease in value. And with a lot of time until expiration, that price movement shouldn’t be very large.

But what happens if the market makes a big, sustained move in one direction? Simply put, the delta of the wrong side of our trade will get crushed (i.e., will move closer to 0.0), while the delta of the right side of the other side will move closer to 0.5. The more the deltas of the two sides diverge, the more their price action will diverge as well. In our example, let’s say the SPY falls all the way down to 142.40, and hovers in that area for several days. Let’s say there are now only 2 weeks until expiration. What would happen is that our 146/148 calls will have become worth very little, while the value of the 140/142 puts will have jumped significantly. But here’s how unbalanced delta can really hurt: as the index price moves down, the calls lose value at a slower rate than the puts gain value. So if SPY falls further to 141.80 – beyond the strike of our short put, we’ll lose more money on the put side than we’ll gain on the call side. And the longer we keep a position that is significantly outside the market price (i.e. as long as the price is beyond the range of our spread), the less likely even a favorable reversal will help us catch up.

Luckily, if the index price starts to threaten our position, we don’t have to just sit idly by. Although our Trading Rules tell us not to exit early, and while we’re very wary of “overtrading” or overthinking a position, there are a few things we can do to adjust the trade to take advantage of big market movements.


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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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