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In This Issue:
Today’s trader must comprehend the strategies that allows success without having to predict market direction.
June 26 , 2008
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Published By InsideFutures

 

 

 

 

 

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& Options Guide

 

 

 

 


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Delta Neutral Trading - Part 1: Buying
By Joseph Ponzio of Opvest – Option Investments Inc.

With uncertainty in the economy, in the housing market, and on Wall Street, sophisticated investors are looking for a 'flight to quality' by cashing out their paper assets and getting involved in tangible asset classes, such as commodities. The multi-dimensional aspects of option trading have caught the attention of today's trader. These leveraged vehicles, if used properly, can have success under volatile market conditions, during stagnant periods, and in trending markets.

(continued below...)


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As always when investing, there is risk of loss and it is important, before executing any option trade, to analyze the psychology of the market and understand the current condition of the market. Doing this properly could result in identifying over or under valued positions, allowing the investor to move forward with the appropriate strategies. Because we've witnessed unprecedented levels of volatility recently, today's trader must comprehend the strategies that allow you to have success without having to predict market direction. One technique, used by some of the largest and most successful trading firms, is the trading concept 'Delta Neutral'.

Investors should be aware that trading futures and options involves a substantial risk of loss and is not suitable for everyone.

Delta Neutral trading is based upon the principle in which an option's delta changes as the option moves further in or out of the money. The delta of an option is the rate of change in an option's price relative to one unit in change in price of the underlying asset.

While call options have positive deltas, puts work inversely, with negative deltas and the term 'Delta Neutral' refers to any strategy where the sum of your deltas is equal to zero. For instance, if you were to purchase 10 call options, each with a delta of .50, and simultaneously buy 20 puts options with a delta of -.25, you would be left with the following:

(10 calls X .50) + (20 puts X -.25) = 5.00 + -5.00 = 0.

The total delta on this position would be zero, also known as 'Delta Neutral'. It is important to have the sum of deltas as close to zero as possible, establishing equal leverage on both sides of the market. Performing this during execution is one key component to success with this strategy. The reason being, markets can go up and they can go down, and sometimes they trade in a channel. The advantage to this strategy is that it doesn't force the investor to decide on a market direction. So, once the underlying asset makes its move, the options on the correct side of the market will increase in value.

The rate of increasing deltas on the options moving closer to their strike price will outweigh the decreasing deltas moving away from their strikes, ideally making more on one side than you lose on the other. One half of this trade is all but guaranteed a loser, and you must overcome the loss by earning more premium on the options that are moving near your strike, making them in the money. The rate of increasing deltas on the options moving closer to their strike price will potentially outweigh the decreasing deltas moving away from their strikes, ideally making more on one side than you lose on the other. When markets become flat, or have low levels of volatility, this approach can struggle, resulting in a loss. The beauty is if the market doesn't decide on a direction, the option premium paid during the purchase is what is at risk, plus commission and fees. One big reason today's investors are being drawn towards options is because of the limited risk associated with purchasing options. You can't lose more than you pay for an option, less commission and fees, and that provides peace of mind to those looking for an alternative.

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There are a few ways to structure positions using the 'Delta Neutral' approach, and they are commonly referred to as 'straddling' or 'strangling' the market. It is possible to structure long option positions, short option positions, and limited risk option spreads. While one strategy is looking for a breakout in either direction, the other wants the market to trade within a range. When trying to identify the right approach, consider the volatility levels, studying technical indicators, analyzing data through computer modeling programs, and confirming with fundamentals. Remember, option investing is not for everyone and you can lose money, so take your time reviewing all information before coming to a conclusion. Once that is decided, it may be time to apply the appropriate 'Delta Neutral' strategy in the market.

Buying Options

The factors that drove commodities to record levels recently still exist. The decline of the dollar, inflation, increasing global economy, bio fuels, supply concerns in Oil, recession and possibly stagflation are all reasons the bull market in commodities should continue. On the contrary, it appears the Fed is done with interest rate cuts and which could be the catalyst for a big correction that is so long over due. By using long option positions with the 'Delta Neutral' concept, investors need big market movement in one direction or another to be successful. In most cases, experienced traders have one position following the trend and another waiting for the correction. The disparities we've identified that are unfolding in the marketplace right now appear to be in a perfect state for this strategy to exploit. Although 'Delta Neutral' trading does require some patience, one great characteristic about this advanced approach is that it takes the emotional aspects out of trading. With long option positions on both sides of the market, the investor must simply wait for the market to make its move and make the appropriate adjustments. Once the strategy is in place, and the market has decided on a direction, the option premiums will begin to fluctuate and the 'Delta Neutral' technique should begin materializing.

Crude Oil

The energy sector has become the leader of the pack amongst commodities, which have soared over the last year, largely in part, because of the decline of the Dollar and rising inflation. One market in this sector, Crude Oil, may be in a perfect condition to apply the 'Delta Neutral' technique. The Crude Oil market has increased by more than 110% in value during the last year, trading from $60 a barrel up to $138 a barrel most recently. Prices at this level are putting tremendous stress on the global economy and there is increasing pressure for price alleviation, but the market has continued to trend higher. Geopolitical influences in Oil supplies have been intense lately. The attacks in Nigeria and Northern Iraq have disrupted the supply flow and that has been reflected in the inventories numbers that are reported every Wednesday by the American Petroleum Institute. The drop we've witnessed in the Dollar, sparked by the Fed cutting interest rates, has been a huge factor in the increase of Oil prices because this market is valued in Dollars. Some analysts believe the bottom in the Dollar has been established and in a statement last week by the Fed, they implied they were done cutting rates, in order to alleviate the concern of inflation. If this is true and the Dollar shows some strength, a long overdue correction could be around the corner.

This type of contradictory information is why the 'Delta Neutral' trading technique may be appropriate for the current condition of this market. If the market trends higher, the long call positions could profit, and if the correction occurs, investors could profit from long put positions. Again, in order to profit, you must first gain more than the premium paid when establishing both sides of the trade. If the market has a stagnant period, and trades in a tight range, the premium of the options could deteriorate and you could lose on the trade. There is always a risk of loss, and in this case, when buying options with the 'Delta Neutral' concept, traders need the market to make a move one way or another because staying flat at its current price will result in a loss.


Past performance is not indicative of future results.

There is no guarantee that Crude Oil will remain this volatile, but I do believe that the market won't stay at its current price for long. With this in mind, I am recommending purchasing long call and long put positions with expiration after the fall. We want to be involved in this market throughout the volatile summer months. This period has increased demand due to the driving season as well as the supply concern that loom during hurricane season. This market reacts violently to fundamental news, and it appears to fit in well with concepts of this approach. Nobody knows where Crude Oil prices are going, but it's likely that prices won't tier off at $138 a barrel. It's probable that the market will continue to run, or the market will sell off and because every investor is unique, and has his or her own set of risk parameter, investors should structure positions based on premium levels that are suitable for the portfolio. If you are serious about option investing, and utilizing advanced strategies, I'd be happy to discuss how we can implement the concept of 'Delta Neutral' into your portfolio today. 

Be advised that trading strategies such as 'Delta Neutral' do not guarantee profits. Trading futures and options involves substantial risk of loss and is not suitable for all investors.
About Today's Author:

Joseph Ponzio
Sr. Commodity Trader
Opvest – Option Investments Inc.
(800) 900 8000 ext 236

Born and raised in beautiful southern California, Mr. Joseph Ponzio developed a passion for swimming at a young age. Felling limited during college as a member of the swim team at Long Beach State, Mr. Ponzio expanded his athleticism into competitive cycling. For 17 years, Joseph entered cycling competitions and triathlons; he even competed in the Ironman competition. Other than being involved in athletics, when away from the market Mr. Ponzio enjoys spending time with his wife of 15 years and his beautiful 3 year old daughter. It was Mr. Ponzio's need for competition and excitement that lead him to his real passion, trading commodities.

After witnessing the stock market crash of 1987, Joseph became captivated by the financial industry, and decided to pursue the tangible asset class commodities. Mr. Ponzio quickly discovered his natural ability to trade and manage risk. He has never looked back since! Today he feels Opvest, provides him as well as his clients the greatest opportunity for success. Joseph is a firm believer in a combination of discipline, experience, and proper money management being the key elements to successful trading.

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