I always say that a responsible person, before diving into the ocean, must first at least learn to swim. The financial markets are like stormy oceans, and learn how to create and manage a delta-neutral position is like learn to swim.
Creating a delta-neutral position in WTI crude oil involves using futures and options to offset the directional risk. Here’s a simplified explanation:
- Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset. For simplicity, think of Delta as a measure of how much an option’s price will change compared to that of its underlying asset. For example, the price of a WTI crude oil option with “delta 0.50” will change 50% of the change of WTI crude oil future.
Establishing a Neutral Position:
- Start by buying WTI crude oil futures. So, now your position’s delta is “+1”. This means you’re betting that the price of crude oil will go up, and your position is completely exposed to market fluctuations. If the price moves +/-1%, your position will gain or lose 1% of its initial value.
Offsetting with Options:
- As your delta is positive, to offset it, you need a negative delta.
- Purchase put options: These give you the right to sell crude oil at a predetermined price (strike price) within a certain expiration date. As the put options’s delta is negative, this offsets your long futures position, providing a hedge against potential price decreases.
- Choose the number of put options and their strike prices based on the delta of your futures position. You want the total delta of your options to roughly offset the delta of your futures position. In our example, the future provides delta +1, then we need a 2xPut option with delta -0.50 to provide to our overall position a delta -1
- (+1-1=0) Delta neutral achieved!
- Regularly monitor the delta of your combined position (futures + options).
- If the market moves, you may need to adjust your options positions to maintain a delta-neutral stance.
This is the basic way to create a delta-neutral position, and remember, delta-neutral does not guarantee that there will be no losses. It just helps minimize the impact of price movements. Other factors like implied volatility(Vega), time decay(Theta), and transaction costs, have a strong impact on your position. We will break down in detail how to manage the risk using the other Greeks (vega, theta, gamma) in our next posts.
The derivatives are not suitable for all traders and investors. Always be aware of the risks involved and consider consulting with a financial advisor before implementing such strategies.