How To Delta Hedge Your Options Portfolio - YouTube

Welcome back to another lesson form NavigationTrading!

In this lesson, I want to talk to you about delta, and more specifically, how to delta

hedge your portfolio.

So first of all, what is delta?

What is this so called delta that we speak of?

And there's a couple different ways that we use delta to trade.

At NavigationTrading, there's really two specific ways that we reference delta.

The first of which is delta is the probability of an option expiring in the money.

So let's go the platform and show you an example, and then we'll come back and talk about the

second reference to delta.

So if we take a look at the platform, and I've just pulled up and option chain, this

is in QQQ, the Nasdaq ETF, and what you'll see is I always have one of my columns set

to delta.

And so what that means is the way you can think of that is the delta that you trade

has about that probability of being in the money at expiration.

So if we are buying or selling the 20 delta call, that means there's about a 20% probability

of that option expiring in the money at expiration.

You can see where the shaded line meets the black, and that is the at the money options.

And so as you can see, those deltas are always right around 50, both on the call side and

on the put side.

And that's because there's about a 50/50 probability of those options expiring in the money because

they're right there at the money right now.

The further away you get away from the current price, the lower the probability of that option

expiring in the money.

So just remember delta when you're when you're looking to enter a trade, that delta is the

probability of an option expiring in the money.

Now, let's talk about the second reference to delta and this is the one that we're going

to focus more on for the rest of this video, and that is delta is the directional bias

of a position or group of positions, okay?

So just think of delta as direction.

If you're long delta, you want that stock to go up to benefit your position.

If you're short or negative delta, you want that stock to go down to benefit your position.

Let's take a look at some of the different positions and how the delta or direction of

these positions is affected.

So on the left I'm showing some examples of some negative delta positions.

Some examples of that would be short stock.

If you're shorting a stock, you want that stock to go down, you benefit from that stock

going down, and so that's a negative delta position.

Long puts.

If you buy a put, again, your directional bias is to the downside.

If price goes down, your position is going to benefit.

Short calls, short call verticals and long put verticals, these are all short bias or

negative delta positions.

On the right hand side we have positive delta positions, so long stock, long calls, short

puts, long call verticals, short put verticals.

All of these are long biased or directionally positive bias, so they're positive delta positions.

We benefit when the stock goes up and that's what makes money on these trades.

Now in the middle are some of our core strategies that we teach at NavigationTrading, and these

are what we call delta neutral positions, meaning we don't care which direction the

stock goes as long as it stays within a specific range.

That would be like iron condors, strangles, straddles, butterfly spreads, calendar spreads.

When we put these on, price is typically very centered within that spread, within that range,

giving us what we call a delta neutral position.

So again, just think of delta as the direction of your strategy or the directional bias of

your portfolio.

So going back to the initial question, how do we hedge our portfolio using delta?

How do we delta hedge?

You've probably heard that term before, I'm going to delta hedge my portfolio.

Or how does that work and how do you do it?

Well, to start with, if you have a bunch of long stock, or long calls, or short puts,

if you have a bunch of these trades on, and your overall portfolio is long delta or positive

delta, meaning the way that you make money is if the market or the underlying stock goes

up, but you are nervous that there might be a correction or some downside in the market,

what you can do is you can add in some negative delta positions so then you can short some

stock, or you can buy some puts, or short some calls, and you can add these positions

in to help neutralize your delta.

The other thing is, obviously you can enter the trades with delta neutral positions like

iron condors, and strangles, and straddles, and so forth.

So those are the ways you can kind of work these different positions, these different

directional bias positions against each other to help neutralize your overall portfolio.

Now, let's go to the platform and take a look at a real life example with a current portfolio.

So if I go to my monitor tab, I have a bunch of different positions on, I have them categorized

by the time, by the date or the month that they expire.

So I've got one position left in March at the time of this recording, I've got a bunch

of them in April because that's the main active month in the options, we've got a few that

are futures out in May, then we've got one in earnings that expires next week.

So if we take a look at the delta of the portfolio ... Let me uncheck this first.

If we take a look at the delta of each position, you'll see an EEM.

We've got a negative delta of 284.

So that's a directional bias.

We are short EEM.

We want the price of EEM to go down.

And what that reference is, is 284 negative delta.

So for every dollar EEM moves down, we would make $284.

For every dollar EEM moves up, we would lose $284, okay?

So that's the directional bias and that's what that delta number means, and it works

a little bit different on futures so don't don't get freaked out by that big number.

But you can see the different deltas for each of these positions.

Now, the difficult thing to look at if you are trading positions like EEM, which is an

emerging markets ETF /6E, which is the euro currency, /ES, which is the S&P 500, soybeans,

apple, DIA, EWW, which is the Mexican ETF, EWZ, the Brazilian ETF, FXI the Chinese Large-Cap

ETF, GLD which is gold, IWM, Small-Caps, IYR which is real estate.

QQQs, Nasdaq, SPY, XLE which is energy, XLV which is health care, XRT which is retail,

nat gas, tenure notes, wheat, Oracle stocks.

So we've got all these different types of symbols that are ... a lot of them are completely

uncorrelated.

And so the question is, how do you use delta to look at your entire portfolio because you're

trading things that are completely different?

It's like looking at apples, and oranges, and pineapples, and bananas, and grapefruit

and all these different things.

How do you compare apples to apples when you're trading so many different symbols and uncorrelated

symbols?

Well, here's what you can do.

In thinker swim, you can check this little box, this is beta waiting.

And what we like to do is we like to beta wait this to SPY, the S&P 500.

So this gives us an idea of if SPY moves down a dollar, then now look at EEM, now look at

the delta, it's minus 53, so we would make $53, okay?

What if this SPY move down a dollar?

Well, how would that affect the 6E?

How would that affect the euro?

Well, we would make $67.

If SPY moved up a dollar, we would lose $67.

So that's how you can use delta, and that's how you can hedge your positions, and that's

how you can bait wait it to SPY, so that you're comparing apples throughout all your different

types of positions, okay?

So when we look at this, now what you'll notice is, okay, we've got 53 delta here, -53 delta

here, we've got -414 delta here, -27 here in May, and about 15 here in this position.

So add it all up, we've got about, give or take, let's say 470 delta, just looking at

it real quick.

Now the question is, is that too much?

In other words, I have a short bias in the market, so I want my overall portfolio to

have short delta or to have negative delta.

Meaning, I want to benefit if the market moves down.

And the reason I do that, we talk about this all the time with our pro members, is that

when we are selling premium and doing these delta neutral strategies, these range bound

strategies, we have to protect ourselves from downside.

Because if the market starts moving down, sometimes the velocity of a down move can

be much greater than the move when the market's going up.

And we saw that just in February at time of this recording, its February 2018.

We saw this huge move down.

Now, the market continued to reap higher.

So it almost looks like it moved up just as quick in this case.

But the velocity of a down move is much quicker and more violent many times than that of an

up move.

You've probably heard the term the market takes the stairs up but the elevator down?

Well, that's why we keep short delta or negative delta in our overall portfolio to protect

ourselves from that type of move.

Now, the question is, how much delta should I have?

If I'm from biased to the short side, how much delta is enough?

And that's kind of the magic question, that there's no right or wrong answer here.

The way that we look at it is we want our negative delta to be about ... We don't want

to get much over four or five times what our overall theta is, okay?

Now this is getting into theta which is a topic for another video, but that's basically

the amount of money that will make each day if price and volatility stayed exactly the

same.

That's our time decay.

That's our daily paycheck.

That's how much the options decay on a daily basis.

And so we're selling premium and doing different strategies in all these different underlyings,

giving ourselves positive theta overall to take advantage of that time decay.

And so we look at the difference between theta and delta to determine those values.

So if I have ... So we have six or seven theta here, 136 here, so about 142, 160 ... so about

140.

And then we've got about 470 negative delta.

So that's between three and three and a half times.

We have about three and a half times the amount of short delta as we do positive theta, and

that's kind of right in line where we want to be.

I mean, if the market has a huge sell off, we're going to have a lot less short delta

because now the market has moved down and taken away some of that short delta.

If the market continues to climb higher, it's going to add some short delta.

But as long as we stay within that kind of a one to one, or one to five times the amount

of short delta relative to the theta, that's how we measure our portfolio and that's how

we look at it from a standpoint of utilizing delta to help hedge our portfolio and manage

our overall directional risk.

So I hope that was helpful.

We'll see you in the next lesson.

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