Having established a delta-neutral (or market-neutral) trade, what next? When and how do we take our profits?
These questions are important to any mature trading strategy, but you will have to put more thought into managing a neutral delta position than most vanilla swing trades. It should address the same needs as a swing trade: strictly limit potential loss, set profit targets, how long you will allow the trade to progress, etc. sensitivity to what is happening is required.
While each trader should map out the details of their own trading system, I suggest you consider two general principles when deciding how to manage delta-neutral trades: a volatility target exit or a rebalancing delta.
Volatility Target Exit – similar to finding a profit target in swing trading. Most market-neutral trade setups are based on finding stocks with lower than normal implied or historical volatility. When the expected increase in volatility occurs, we can liquidate our position. Assuming we don’t suffer too much from time decay on either leg of the position, we should reap some profit.
rebalancing delta – this approach requires more finesse, but is worth developing as a skill. When a delta neutral position is initially established, small moves in the underlying stock cause almost no change in the neutral position. But as the stock makes some kind of sizable move, the delta of the position starts to slope more positively or negatively. This is desirable: it is that steepness in the delta that produces our profits.
At the same time, this delta tilt means that we suddenly have something to lose: we start showing gains and if the stock goes back to where it started at the beginning of the trade, our gains will evaporate. How do we protect it? We protect our profit by rebalancing the delta on our position.
As an example, imagine that we have established a neutral position consisting of 90 shares, balanced against two put options with a combined negative delta of -0.90. When the stock starts to move, we have two broad scenarios to consider:
1) stocks move steadily up – put options lose value as stocks gain value, but the exchange rate soon starts to favor the stock. Let’s say the negative delta on our position moves to -0.60 (meaning the put options will move the same as 60 shares sold short); at this point, a dollar movement in the underlying will mean a change in the value of our position by $30 (delta of 90 shares – delta of 60 put = 30). To protect our profits, we restabilized the position by selling 30 shares. Now our 60 stocks balance again with the current delta of -0.60 from the put options.
two) stocks move steadily down – in this case, the put options are gaining value as stocks lose ground, and they are doing so at a fast pace. Let’s use a reverse example of the last one, imagining that our shares have fallen enough that the combined delta of the option contracts is now -1.20 (meaning that put options will move the same as 120 shares sold short). Since we only have two contracts, and selling just one would set our sell delta to -0.6 (keeping us off balance), we can either buy 30 more shares OR we could write a put option while simultaneously selling 30 shares. Either option would balance the delta, but since buying more shares obviously means increasing our capital outlay, I prefer the second option: selling part of both legs in our position, thus taking part of the current profit.
The need for finesse arises when trying to determine “when” you will rebalance. You can base it on market activity (timing the highs and lows of the move, but if you’re good at it, your need for a market-neutral system is small), or you can pinpoint specific triggers on profit percentage or how much delta has changed . . Paper trading for some time before using real money will help you decide on the right method for your needs.