Options are a great way mitigate risk in the markets as discussed before. In this example I will illustrate how a “delta spread” can be used to stay market neutral and adjust a position to take advantage of time decay.
This is an advanced strategy and I would not recommend this or any other trade on this blog. For more information about this see my ***disclaimer***
I will use (RIMM) as the stock for today’s trade of the day. With ($RIMM) trading down in a range of $35-$50 we have come upon an opportunity to exercise a Put spread using deltas to stay neutral. By selling twice as many out of-the-money (OTM) puts as in-the-money (ITM) on two different strikes we have generated a Put spread which will become more profitable if the stock stays within the desired range until expiration. If the stock heads higher the holder of the put spread will take no loss, for the premium brought in from the sale of the OTM puts will still be in possession.
With deltas we can find the neutral ratio of the spread and adjust into expiration.
If we take the -0.54 delta from the ITM, or higher strike and divide by the -0.40 of the OTM, or lower strike we find out how many puts we must sell to become market neutral. Let’s try it!
-0.54 / -0.4 = 1.35
This ratio indicates we must sell 1.35 puts for each put bought. As time progresses the premiumes decay and the buyer will have his/her profit. With any trade the stock will adjust in price, and if the postion moves to far the holder can adjust his/her postion back into neutral by buying another 50 or selling another 45.
Stay hedged, stay happy!