A delta neutral trade is one in which a long and short option contain offsetting delta so that the net delta is at or near zero. Delta is a measurement of the degree in an option's price movement when the underlying moves.
The theme of delta neutrality can refer to many differently constructed strategies including spreads (covered and uncovered) and straddles. When an option position is covered with long stock (one short call offsetting 100 shares of stock), the delta neutrality creates an equivalent stock position. This position moves up or down and tracks the 100 shares synthetically, creating a form of leverage.
The delta neutral accompanying long stock in theory wipes out risk on both sides of the option trade (the long has no market risk because it is paid for by the short; and the short has no market risk because it is covered). However, as volatility changes, so will the relative risks of each option. If the risk does offset at the point of entry, traders have a great advantage in being able to react to movement in either direction (or both). The risk applies at the time of entry and subsequent movement can lead to rolling, closing, and expiration.
One variety of this concept involves two short options, one call and one put. The theory behind this is that offsetting exercise risk cancels out in the same way as a covered long and short position. But this is not accurate. Exercise risk exists separately for both sides in a trade of a short call and a short put. It is not neutral. Exercise of either can wipe out the initial credit received and exceed that credit by many points. Making matters worse, both shorts can be exercised when the stock moves first in one direction and then in the other. For example, a short call is ITM on ex-dividend date and is exercised; and then after ex-dividend, the stock price falls and by expiration, the short put is also exercised. The risk is especially severe when the two-short position is a straddle. One or the other of these options will always be ITM. In comparison, a spread may involve two sides, each OTM. Whenever using short uncovered options, the collateral requirements have to be kept in mind as well.
It makes more sense to involve delta neutral trading in positions such as the synthetic short stock, consisting of one long put and one short call. The short call pays the cost of the long put, and the short call may be covered (by also owning 100 shares of stock). What is the rationale for this position? The synthetic short stock strategy sets up a situation in which, if the stock price rises, the call grows in value and could be exercised. If you own 100 shares, this outcome is covered. If the underlying falls, the long put will increase in value. Any loss in the stock is offset point for point in intrinsic value of the put. The put can be closed to take a profit offsetting stock losses, or exercised so the stock can be sold at the strike.
This strategy makes sense if you are concerned about downside risk but want to hold onto the stock. For a stock paying an annual dividend above 4%, for example, this is a respectable yield. For that reason, setting up a delta neutral position through a synthetic short stock strategy makes a lot of sense if you own stock, and is safer than a covered call. If you are intent on holding onto the stock because of a high dividend yield, writing a series of synthetics is another alternative. This protects against price decline while keeping ownership of stock. If the short call goes ITM, it can be closed or rolled forward.
In any synthetic stock position, closing the long option leaves the short option open. If this is a covered call, the position reverts without added risk; but if uncovered, the collateral requirements kick in immediately.
To find out about collateral for any position involving short options, check the free download at CBOE Margin Manual
Michael Thomsett blogs at the CBOE Options Hub and other sites. He is author of 11 options books and has been trading options for 35 years.