Understanding How Futures Option Spreads React By Using Delta
There are a variety of ways to attack the beast which is trading Futures Option spreads. One method is trading spreads which you’re able to profit from time decay. How you proceed is to sell (put) options which you think will lose more time value than the options which you buy (call).
Another method is to buy and sell options which are based on their deltas. These trades at times are referred to as Delta Neutral Trades. These are particular option trades where the total delta of all of the options are zero. “At the money” options will have a delta of 50.
• If you buy an at the money “call” option, you’ll then have a delta of +50
• If you sell an at the money “call” option, you’ll have a delta of -50
• If you buy an at the money “put” option, you’ll have a delta of -50 and
• If you sell an at the money “put” option, you’ll have a delta of +50
Deltas are determined by where you’re wanting the market to go. For instance: If you sold an at the money “call,” then know where you’d want the price to move to. You in this case would want that instrument to go lower. So what you would have is a delta of -50.
If you look at the majority of “money” options, you’ll find that they’re usually not at 50. The reason for this is because they’re not exactly at the money.
But what we do is still refer to these as “at the money” options because they’re the ones which are the closest to being there. So they may have a delta of either say 47 or 53.
If you purchased an option, one at the money, a call, as well as sell one at the money, put, then you’d be delta neutral. The call option would have a +50 delta, while the put option would have a -50 delta.
The total as a result is zero since they offset each other. This is an extremely simple delta neutral trade.
Delta Neutral Trades
Another delta neutral trade is what’s known as a ratio back spread. For instance, an example of this would be to sell (put) an option which is at the money, and then buy (call) a higher cost out of the money option.
You might then sell one call option at the money, which is at delta -50, and then buy two call options which are out of the money, which are at delta +25 each. You’d then be delta neutral.
You would then want to place this on at even or for a credit. You can also place it for a debit, but then you’d be concerned about the direction of the market.
If you place it on even money or for a credit, and the market happens to be lower at expiration of the options, then you would break even or at times earn a small credit.
If you place it on for a debit, then you would lose the debit amount if the market happens to be lower at expiration.
In either of the cases, if the market happens to go higher, then you’d have an opportunity for unlimited profit, this since you would have purchased more options than you would have sold.
Ratio Back Spreads
The majority of traders will suggest that you trade the ratio back spreads for options which are far (months) in advance. This because you would then have more additional time to be correct when or if a big move occurs.
The issue however is that you will be giving up too much for the time advantage. The options which you buy out of the money aren’t priced at an advantage, this when compared to the ones which are at the money.
You can look at the “theta” to determine how much each option will lose on a daily basis, or per week.
You’ll also be able to see how much time that you have left in the trade, as well as the difference in the strike prices between the option which you sell, and the options which you buy, and if they’re too much.
It will require a bigger move before you’ll realize any potential for profit.
If you happen to be expecting a big move, then think out of the box and begin to look at the options which have 20 to 40 days left. The options which you buy compared to the options that you sell, should be priced better. This since everything becomes relative.
So the next time that you hear someone who recommends the same ratio back spreads, take a look instead at the difference months to see where the advantage is.