If you want to upgrade your trading level, gain consistency, become long-term profitable, you have to move for this type of trading.
Last couple of weeks we discussed the importance of Implied Volatility in options pricing because the majority of beginner options traders fail to understand it and how important is volatility and how it can be used to our advantage.
The majority of beginner traders are options buyers and miss out on the chance to profit from high volatility declines. This type of trading strategy is called Delta Neutral. One book that I can suggest that explores this concept is “Option Volatility and Pricing” by Sheldon Natemberg. A must-read if you want to move your trading into the next level.
Delta Neutral trading can be used to explore extremes in volatility. The goal is to enter a position that starts in a Delta Neutral (Delta near 0) state and adjust accordingly as long as underlying moves to maintain Delta neutrality. Please bear in mind that not only when underlying price moves that impact Delta, but also when there is an IV change or time passes. If we keep Delta under low value and Volatility changes according to our predictions we end up gaining money from this type of trade.
For example, if we are under a low IV environment and we anticipate a market move down which will cause a spike in IV, we can buy an ATM (at-the-money) Straddle. This strategy involves buying a Call and a Put at 0.50 and -0.50 Deltas that both neutralize each other and the position will gain if market moves in either direction and/or if there is an increase in volatility. By then, if Delta of the position becomes, for example, at -10, we can buy 10 shares or buy 1 Call at 0.10 Deltas to turn our overall Delta close to 0 again (become Delta Neutral).
But now, you may comment that this should not be so simple. Indeed, it is not so easy because with options everything varies and one key issue is time value! As time passes, in the given example, we are buying options, and hence the position will lose money due to options time decay. The strategy described above included only long options that will produce high negative Theta! If the increase in volatility is not fast enough, the position will lose from time decay even if there were an increase in options volatility.
For the ones that are following me, you are now concluding the “Ride Trade“ is a Delta Neutral strategy. But a different kind of Delta Neutral strategy that explores not only Volatility changes but is also hedged to Theta! In fact, that strategy produces a positive Theta and we are not stressed about losing money with options time decay. It captures value from time decay because it involves selling options.
Additionally, all the adjustments made take into consideration not only Delta adjustments but also minimizing Theta impact, maintaining it as much positive as possible! Ride Trade solved the problem being Delta Neutral and gaining from time passing. Even, being Vega positive, it can profit in a decaying volatility environment due to a time premium that will compensate for it!
But now, you are thinking that “Ride Trade” is the perfect trade! No, it isn’t! There is no such trade! There are circumstances where it does not produce profits, For example, if there is a fast decrease in IV (with a fast market movement up on SPY or QQQ) just after the trade is entered when Theta is still low. That is why we can have other strategies we can combine with VXX to offset the potential losses.