delta neutral

The New York Stock Exchange (NYSE) matches buyers and sellers of stocks.  An auction system, high buy and low sell being matched by Specialists.  Trades taking place when the two agree on price, one coming to the other.

Market orders mean agreeing to the best price at that moment in time.  The moment in time the Specialist gets the order, not the moment in time it was placed.  Market orders are a truly scary thought.  I’ve heard countless stories dealing with market orders, all of them horror stories!

An orderly market requires a relatively equal number of buyers and sellers in a close proximity of price.  Trading halts when an order imbalance occurs.  The Specialist’s job entails filling market orders fairly.  They need time to determine the price for matching market buys with market sells.  In an effort to be fair, trading might also halt pending news.  Most major announcements come before or after the opening bell.

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The NASDAQ market works differently.  Unlike the NYSE’s trading floor, the NASDAQ trades stocks electronically.  And unlike the NYSE Specialist system, the NASDAQ uses Market Makers.  The Market Makers create a fair and orderly market by bidding and/or offering.  They try to buy stock at their bid or sell stock at their ask.  They try to make the Bid/Ask spread like the option Market Makers.  They are not required to be on the floor of an exchange.  With limitless location possibilities and only the volume and size of trades to deal with, most NASDAQ stocks have large numbers of Market Makers.  It takes commitment to be a NASDAQ Market Maker.  It’s not a part time job.  It also takes an inventory of stock to trade from.  This calls for large sums of money.

Option Market Makers are like a blend of the NYSE Specialist and the NASDAQ Market Maker.  Options trade on an actual exchange like the NYSE, but Market Makers offer liquidity with ready Bids and Asks.  The major difference lies in the number of possibilities.  You either buy stock or you sell it.  Option trades include both buying and selling, both puts and calls, with countless strike price choices.

Option Market Makers don’t start with a large inventory, they create the option contracts as buyers and sellers appear.  They would just as soon not ever own stock.  If they do, it means the buyers and sellers of options are not in equal proportion.  Their profit comes from buying at bid and selling at ask, called the Bid/Ask spread.  Option Market Makers buy and sell numerous option contracts, not always the same ones.  Through the use of Delta, Market Makers and option traders are able to remain basically market neutral or completely hedged.

Delta is a measurement of change in an option compared to the change in the underlying.  Delta is also the measurement of relativism between option contracts.  This relativism is what Market Makers use to hedge.  They try to remain at Zero.  Neutral.

To show how Market Makers trade Delta Neutral, let’s make some assumptions.  Let’s say an in the money (ITM) call has a Delta of .75, an at the money (ATM) call has a Delta of .50, and an out of the money (OTM) call a Delta of .25.  If a retail investor buys an ATM call from the Market Maker, the Market Maker is now short a Delta of 50.  Remember 100 shares per contract, means .50 x 100, so the decimal is dropped..  If someone then sells two OTM calls to the Market Maker, the Market Maker is then buying a total Delta of 50.  So selling -50 Deltas and buying +50 Deltas, equals zero Deltas.  Therefore the Market Maker is considered Delta Neutral.  A snapshot risk free trade.  Snapshot, meaning at the instant the trade takes place.  Technically, the risk is the Gamma, the change of Delta.

Puts are measured in negative Deltas.  This can be quite confusing.  Delta measures the change in the option verses the upward movement of the underlying.  So if your stock moves higher, the put would move lower.  Disturbing as it seems, two negatives make a positive.  If the stock price drops, with a negative Delta, the put option increases.

Selling a call option with a Delta of .50 and buying a put option with a Delta of -.50, the net effect is zero.  Buy 20 options with Delta of .75 sell 60 contracts with a Delta of .25, Neutral.  Long 20 contracts with a Delta of .75 = + 15000, selling 60 times .25 = -15000.  15000 minus 15000 equals nothing.  Hedged or Delta Neutral.

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