Hey guys, I'm a freshman so go easy if this is a stupid question..
I was reading about delta neutral hedging in options trading and think I have started to get a grasp on it, but I wanted to make sure if I was on the right lines.
My understanding so far is that the entire portfolio is summed to a delta of 0. So, for example, if someone buys a call and a put at the money (say at a strike of 100), the delta sum is 0.5 + (-0.5) = 0. This part wasn't that hard to grasp.
What confused me was that, suppose the price drops to 90. The gains from the put would be offset by the losses on the call. So, is this really just a bet on the implied volatility of the stock? For example, are they betting that the stock has a volatility of 20% (is this the correct calculation for the implied volatility), such that the stock will drop to 90, where they can cash in on the put, and then rebound up to, say, 110, where they cash in on the call. Thus benefiting from both, yet hedging their risks by being delta neutral?
Thanks a lot for your help!
Also, wouldn't they still end up losing money if the stock stayed stagnant because of time decay (theta) and the fact that both options may expire without ever reaching their strike price?
A person who delta hedges generally is buying or shorting stock to hedge their obligation in their option position. For example, I sell a call with a delta of 0.50 and buy 50% of the shares in notional to hedge my risk that the stock goes up. If the stock goes up, I need to buy more shares and if it goes down I sell shares. The risk in this example is that the stock gaps up. Assume it went up 50% instantaneously. Now I owe 50% to the person who I sold the call, however, since I only had shares for 50% of notional, I lose.
You're correct on the volatility. Remember that volatility is a factor in option pricing, so logically the higher the volatility of the underlying, the pricier the option. As an example, if I believe that AAPL volatility has risen dramatically and caused the price of AAPL options to rise, I can bet that implied volatility will decrease by selling out of the money calls delta neutral, hoping to buy back at a later date when the volatility hopefully decreases. There are other options (no pun intended) than purchasing options to delta hedge; you can also buy/sell delta shares of the underlying. But don't forget that delta changes as well (this is your gamma), so to maintain proper delta hedging you'll have to adjust your position at times.
For the second part of your question, if you cash in on the put, you're not delta neutral any more so that kind of defeats the purpose.
Just saw Nabooru's post, so I'm probably repeating a lot here-
Yes, if you buy a ATM put and call, you are buying a "straddle". Thus, you are expecting a certain amount of movement (gamma) to offset the amount you are paying as decay (theta). In the example you gave, when it moves to 90, the delta on the put and call are no longer 0.50 and 0.50, are they? In fact, you will be short deltas, so you buy stock to become delta netural again. Then when you move back up, say to 110, you are long deltas so you sell the stock out, thereby making money on your stock and still remaining delta netural. This is known as scalping gamma (the change in deltas as you move).
If you cash in on the put, you are now long deltas, not delta neutral. You will make money on the rally and lose money as you break down. Option deltas are not hedged with other options, they are hedged with the underlying - futures (like with commodities) or stock (like SPY, GLD etc).
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