Well, it’s 2 am Eastern as i start writing this but I’ve got a 3 hour lab in the morning which is going to be pure torture knowing the amount of news that is coming out in 6 hours. So per request of a few people I talk with on Michael Kudrna’s Live Chat regularly, I’m going to define my primary trade for the next few month’s.
Delta-Neutral strategies are somewhat of a whisper around most stock boards. They are said to be employed by the super-elusive, super secretive Hedge Funds or anyone with a basic knowledge of options and a mathematics degree. The beauty of Delta-Neutral strategies is that the majority of your risk lies in time value and implied volatility of the options you purchase. However knowing this, you can make the latter work in your favor. Time will always be the greatest detriment to holding an option, so be wary. As a general rule most traders never hold options with 2 weeks left to expiry, however a Delta-Neutral Strategy employed in the time of increasing volatility(IE NOW) can benefit greatly from short-term spreads when combined with long term spreads. So let’s get to it.
Many people are speculating with the amount of news coming out where the market is going to go. I don’t like to speculate. I think we can all agree that with the amount of news coming out we are in for some volatility. In order to capitalize on this volatility I chose gold. Why gold? The dollar is at 15 year lows, we might see a massive of influx of freshly printed money, and our economy is in the shitter. Any of the amount of news coming out is going to effect gold therefore we have our volatility.
For this spread I chose SPDR Gold Trust (GLD), and in order to maximize gains i will be using options ONLY. You can do the same thing by buying outright shares instead of calls and put options, just recognize stock shares in increments of a 100 have a delta value of +1.
To start this spread I’m going to be entering a straddle using Fib retracements that i calculated using my pilot g-2 ink pen.(It’s not that i don’t trust software, i just don’t own any)The values chosen from the 100 day chart were from a high of 134.5 and a low of 113.08. from here we can identify the key levels on GLD and pick the best positions to initiate this trade.
The first part of this trade will be initiated using Jan options, on the 100% and 23.6% lines which are 134.5 and 129ish respectively. This is going to be our primary long-term trade in which all short term options purchased to adjust for delta will be used against this. So tomorrow if Gold has not moved much from it’s close of 131 i will be using the Jan 135 calls, and the Jan 128 puts. When entering a straddle you may notice a price difference in the puts and calls. Options are priced using stochastic calculus(namely the black-scholes model or a derivative) which is a topic for another post. However every option has variables that effect it’s price, these are commonly referred to as the “Greeks”. The primary Greeks we will care about are Delta, Gamma and to a lesser degree Theta and Vega. What is delta? Delta is the amount your option will change in value per $1 move in the underlying asset. So if GLD is at 130 and goes to 131, and your call option has a delta of .5, your option gains .5 for every dollar GLD goes up. However the more ITM an option goes the greater Delta becomes and the farther OTM an option goes the smaller Delta becomes. These diminishing returns is what allows a straddle to be profitable whether it hits its price target or not. This is actually defined by the Greek Gamma. Delta is our primary care, for every adjustment that we make will be based on the ever changing delta values on your options. Calls have positive delta’s and Puts have negative delta’s. So entering this position i want my delta to be = 0. If we look the Jan 135 calls have a delta of .411 and the 128 puts have -.357. divide these numbers and we find we need 1.15 puts for every call. This will initially set our delta to 0.
The primary position is thus entered and we can now sit back and wait for the onslaught of news to bounce GLD around. The second part of this trade will be using Nov options to make adjustments on our portfolio. Because i can’t predict the future i cant tell you what options to use yet, so instead let’s use some examples to mentally prepare for what could happen. Say gold drops down to 129 on the 23.6% support. This would change the delta’s of both calls and puts. Your calls delta’s would decrease by .032(gamma) per dollar and your puts would increase by .034(gamma) per dollar. Let’s see how this would effect the balance of the portfolio.
Starting
GLD at 131
Calls Puts
10X .411 = +4.11 11.5X-.357= -4.05 -4.05+4.11 = 0ish(you want to get this as close to 0 as possible but its ok if its off a slight amount.)
Now say GLD drops to 129
Your options delta is going to change by (gamma) X (number of dollars price change)
Calls Puts
10X.347(.411- .064) = +3.47 11.5X-.425(.357+.068)= -4.88
if we add the resulting +3.47 and -4.88 we that our delta value has changed to -1.41. This means we our net short now. In order to correct this we need calls. Say the 130 nov calls have a delta of .47. Well if we buy 3 of them then our overall delta is now 0. Now if we bounce off the 23.6% line we our puts and calls go back to what they were worth when we bought them but the 3 new calls we bought are worth much more. We now have a positive delta on our portfolio and we can sell the 3 calls we bought for a profit. These adjustments are what makes delta-neutral trading profitable. It should be noted that the above values were purely hypothetical. In reality we would wait for breaks below either near term support or resistance and adjust accordingly. If the underlying makes a strong movement in either direction(i personally like 50% and 100% lines), we can sit back and relax and let the long-term straddle pay off massive rewards.
I will update this more when I’m not exhausted and when GLD moves on news. I can be found in MK’s live chat if you want real time updates or send me a message on SA if you have questions.
Disclosure: Straddle GLD, Long GLD, Short GLD
