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Delta Neutral Trading - Unplugged

Posted by Pete Stolcers on June 5, 2006

In the last option trading blog I defined non-directional trading. Let’s look how it has evolved “on the floor”.

Twenty years ago option Market Makers had a tremendous “edge” being on the exchange floor and they made a great living without having an opinion. Orders were verbally represented to the crowd and executed. The information was slowly disseminated and it took forever to know if you were filled. It gave the Market Makers plenty of time to adjust their markets based on order flow. As a veteran in option order execution, I will tell you that there were times when the process felt like a “grab bag”. You would stick your hand in and you never knew what you would pull out. In the “80’s”, Market Makers were able to leg into conversions and reversals with relative ease, locking in risk free profits. They were making great money! Over time, competition and technology started to “bite” into that edge.

By the mid 90’s, Market Makers were forced to develop multi-leg strategies that they could leg in and out of to hedge their overnight risk. Remember, Market Makers feed off of order flow and they only buy bids and sell offers. Their commission costs and margin requirements are a small fraction of the retail public’s and that is still an advantage granted to exchange members. These strategies still exist and can generally be grouped as complex spreads. They include 4-ways and condors and iron butterflies. The premise is that the position is neutral and very hedged. Think about this carefully. Imagine seeing all of the order flow on the floor, paying a dime a contract for clearing (no commissions no minimums), having a fraction of the margin requirements, adjusting your markets instantly based on the underlying and legging into trades. The competitive edge they have over you for complex spreads it monumental.

By the late “90’s” it was apparent the exchanges were going after each other and fighting for listings. The monopoly that had existed (IBM only traded on the CBOE, DELL only traded on the PHLX) was going to be broken up and the bid/ask spreads would have to tighten to attract order flow. To make matters worse, electronic quote systems were improving and electronic trade execution was lightening fast. The Market Makers had to be sharp and fast to survive. There was also the threat of an electronic options exchange (ISE). By the late “90’s”, no one on the floor knew his or her fate.

Even with all of the advantages of being on the floor, these complex neutral strategies were barely paying the bills. By the end of the millennium, Independent Market Makers were making $75,000 a year after expenses. It’s a living, but I don’t think that is what you have in mind. The Independent Market Maker is all but extinct and most have a salaried position (with a year end bonus) with a large firm.

These facts don’t stop people from teaching complex spreading strategies. As long as the instructors know more than you do, they’ll charge you $3000 and tell you how easy and risk free it is.

Non-directional trading is now being played by large institutions with deep pockets, a very low cost of capital, the ability to “leg in”, access to over-the counter markets, minuscule transaction costs and instantaneous hedging programs. They have traders at every post on the floor. Let them have this space. It is a very tilted playing field. These strategies can make money for months on end and all it takes is one big move to lose everything.

Imagine an Iron Condor where you have four bid/ask spreads on the way in and four commissions. Imagine that you have to take one side off. You have another two bid/ask spreads and two commissions. Is the picture becoming clearer?

The point, learn how to become a directional trader.

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Option Trading Comments

  • On 06/08, Al said:

    This is the first time I’ve read an article that gives an honest opinion about delta neutral trading strategies.  After I had attended one of those $3,000 classes, I found the neutral strategies too difficult to setup and monitor. The multiple commissions would eat up any profit from small trading accounts. It is something definitely for the pros. I think your article is right on.  Thanks for the good work.

  • On 04/10, Bob B said:

    This question regards trading Iron condors for premium. I was reading a article from a trader that does IC’s and verticles on the QQQQ. When the delta gets to +- 250 he buys or sells stock to get neutral. I am missing something because lets say the Q’s go up in price to a point that you are -250 delta. That means I need to buy 250 qqqq to get neutral. If the Q’s go back the other way the stock I bought goes down. He says with stock you dont have the grek issue for hedging. What am I missing on this delta neutral angle???

  • On 04/14, Pete Stolcers said:

    The writter of the article is using 250 as a delta and it equates to .25. The delta can never be greater than 1. He is saying that if the short options get to a .25 delta, he starts buying (or selling) QQQQ to keep the position neutral. If he were short 10 QQQQ calls with a delta of .25, he would buy 250 QQQQs (10 QQQQ call contracts x 100 multilier x .25 delta)to keep the position neutral.

  • On 08/25, deepak said:

    I work in financial sector, as a option arbitrager. i know many strategies about options.... but i don’t know much about how to do delta trading. i have read it in the net, but not able to understand how and when to make positions....


  • On 08/25, Valtinho said:

    Hi Pete, regarding your quote:

    “Imagine an Iron Condor where you have four bid/ask spreads on the way in and four commissions. Imagine that you have to take one side off. You have another two bid/ask spreads and two commissions. Is the picture becoming clearer?”

    That is not true. You should place your iron condors based on the mid-point price of the NBBO for the whole spread as a unit and pay only one commission (not 4). If your broker is not willing to do this for you, you need to change brokers ASAP.

    Also, if you are going to trade condors, I think it is a lot safer to simply put on the whole thing, or take off the whole thing. Legging in and out requires perfect timing, which is nearly impossible as far as I am concerned.

  • On 08/29, Pete Stolcers said:

    Yes, you should always try to execute an order between the bid/ask, but unless you are trading the most liquid options, the Market Makers will rarely budge and there is not retail “paper” to take the other side.

    The article was written 4 years ago and yes, commissions are coming down making the strategy more viable.

    I am still not a fan of condors or delta neutral trading. If I don’t have an opinion on the direction, I keep looking.

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