Delta Neutral: Bet Them All, Let God Sort Them Out
Lesson E: The Basics for Understanding Delta Neutral in Finance
“Delta neutral” describes a trading position with respect to options. The names for the letters of the Greek alphabet have been used traditionally by finance to describe quantities representing the price of derivatives and assets. For example, you may have heard of the letter “alpha” used in relation to profits. “Alpha” describes the return on an investment relative to a benchmark index.
Delta neutral is a complex idea, so let’s break it down bit by bit.
Just Plain Old Delta
(I’m hoping someone will make a meme of Delta Burke in relation to the financial use of delta!)
“Delta” has a very specific meaning in relation to options trading. Recall that the point of an option is to speculate on the direction of the price of the asset underlying the option contract. Or to put this another way, the value of the option on which I speculate is derivative of the underlying asset.
So, I can very well take out an option on how I think the direction of a stock like TSLA (Tesla) will go. If I feel bullish about TSLA, I’ll take out a call option; and conversely, if I feel bearish, I can buy a put option.
(Before we go any further, you need to understand how options work. The link in the paragraph above provides an explainer, and from here on out, I’ll be assuming the reader understands the basics of options trading.)
So, “delta” refers to the difference between the value of option and the value of underlying asset. Think of . . .
- how much the change in the value of the option will be
in relation to
- the change in the value of the underlying asset.
Here’s an imagistic way to think of the relational values involved in delta. It’s a pizza with the underlying asset as the base and the option as the sauce and topping. (Think of the sauce as the premium paid and the topping as the strike price. Sorry if you don’t like pepperoni! Admission: I like pineapple and mushrooms on my pizza.)
If TSLA (the base) goes up, we can use a delta value to get a sense of where the option (the sauce and topping) is on the spectrum of earning a profit.
But how?
The Answer: Delta Pricing
Delta can either move up or down with respect to price; and when it moves, it is measured relative to a $1 price change in the asset. So in fact, there are two points of measurement:
- Whatever numerical value of delta is with respect to change;
- A $1 price change in the asset.
We’ll get to some illustrative examples in a moment. But for now, let’s be a little more precise.
One key use of the delta calculation is to determine whether an option is going to be “in the money” by its expiration date. Delta can be any number from 0 to 1 for a call option, or 0 to -1 for a put option. The further delta moves away from 0 for each respective option, the more it is “in the money”. It actually needs to be greater than .50 for a call option and -.50 for a put option. These halfway points are actually and respectively the break-even points where a call or put option is “at the money”.
If you’re with me so far, than to calculate delta pricing you’ll need to know how the pricing works. Here are two examples from Investopedia.
Call option (price of asset goes up)
“[I]f a call option has a delta value of +0.65, this means that if the underlying stock increases in price by $1 per share, the option on it will rise by $0.65 per share, all else being equal.”
Put option (price asset goes down)
“[I]if a put option has a delta of -0.33, and the price of the underlying asset increases by $1, the price of the put option will decrease by $0.33.”
Very nice, so how might this play out in terms of investment and speculation?
Before answering this, we need to cover delta neutral.
Delta Neutral Position
Remember the break-even / “at the money” position where a call option is at 0.50 and a put option is at -0.50?
Delta Neutral is the break-even / “at the money” point.
A Delta Neutral Position (DNP) is risk neutral. So there is in fact at that point no gain or return in the investment.
As we know plain old delta requires at least two investments:
- an option, and
- an underlying asset.
With DNP, those values equalize. More specifically, DNP involves buying a call option or a put option for an underlying asset to equalize the risk position (or balance out the underlying asset).
Imagistically, think of a balanced seesaw where the asset is balanced by the option.
So in each instance of the call and put options, any deviation from DNP in favor of the the respective option would mean a profit —i.e. the asset moves above 0.50 for the call option; the asset moves below -0.50 for the put option.
This means that while DNP can be a safe haven for investment because it’s risk neutral, it can also act as the starting point for profit since investors can speculation by adding call and/or put options “on top of” the asset (like the pizza).
Yada, Yada, Yoda
There is a longer, technical story as to how delta functions within the pricing of assets. The short story is that delta is a metric used frequently in pricing. It is calculated as a ratio.
As master Yoda once explained:
Here’s an example from CFI:
[A] call option has a value of $10, and the underlying asset has a price of $20. The underlying asset increases in price to $23, and the option value corresponds by increasing to $11. The delta is equal to: ($11-$10)/($23-$20) = 0.33.
Now we’re on the way to answering the question about how to speculate and ideally profit from DNP.
DNP and Financial Profit
As you might recall from a previous post, a covered call option is one in which you own the underlying asset and then sell (or write or short) a call option to another investor.
This is a way of hedging your investment in a neutral market. You’re not expecting the value of the underlying asset to rise dramatically, so you can sell options on the assets to make a premium.
To determine how much you would make by selling call options on the underlying asset, you can compare the delta of your stock investment against the number of call options sold. So, for example, you might work out a plan whereby for every 100 shares of stock owned, you sell 1 call option. You would therefore subtract the delta of the call options from the delta of the stock owned. The idea is that the delta of the stocked owned would decrease.
At the same time, you would still be making money on the long position of the stock while at the same time earning money from the premiums of the call options sold.
So, in effect in this example, DNP is a point of reference but not the end goal.
What Is a Quasi or Pseudo Delta Neutral Position?
A quasi or pseudo delta neutral position is specific to cryptocurrency yield farming. To recall:
Yield farming is a way to make passive income by providing liquidity to a decentralized exchange. Liquidity providers typically make money from the transaction fees when based on the proportion of liquidity they provide to a pool. Pools can involve the trade of a pair of cryptocurrencies, or even three or four cryptocurrencies.
One of the worries about yield farming is that as people borrow coins from the pool, the value of those coins changes. If a provider decides to withdraw their coins, that withdrawal is based on the proportion or percentage of coins they originally provided. Impermanent loss results when their withdrawal results in a loss compared to what they initially added to the pool.
What’s important to take away from the above is that even if you go into a liquidity pool, you can add liquidity based on a DNP position with regard to market prices. But within the liquidity pool itself, the prices of the coins will fluctuate based on the borrowing within the pool. As one coin is borrowed or withdrawn from the pool, its numerical amount will decrease while its price will go up (less is more). Conversely, the other paired coin will increase in numerical amount and decrease in price.
A pseudo DNP is one in which the liquidity provider enters with a typical market neutral position, but then adjusts this position to accommodate the fluctuation in prices within the pool. So it’s not really neutral.
In effect, this helps to ensure:
- s/he makes money from the transaction fees; and
- does not suffer impermanent loss.
It’s easy to explain in theory, but extremely complicated to execute in practice; and this is why there are specific platforms that provide automated functions for pseudo delta neutral investment.
Another version of pseudo delta neutral involves entering a pool that is not truly neutral since you’re aiming to make a profit with a slight change in the prices of the assets. As, hiyocoro points out, if the price moves outside that range, then you lose.
How This Can Be Applied
Very carefully. The main aim of this article is to educate the reader on what Delta is and how it can be used. It obviously takes a lot of practice, preparation, and gumption to start employing tactics related to derivatives and yield farming.
It’s as Chuck Norris (Good Guys Wear Black) once cautioned:
“Everything went wrong by the numbers. And that takes planning.”
I hesitate to say that Chuck is the fount of knowledge, but in this case, he might have it right about financial speculative endeavors where the would-be speculator often fools him- or herself into thinking . . . well, “I am an expert.”
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
If you found this helpful, Subscribe to The Art of the Bubble’s free newsletter.
Join us on Discord for live chat and daily updates.
