A normal hedged derivatives position would be a short Nifty futures coupled to a long call near-the-money. If the market falls, the call is sold for a small loss, while the futures gains. If the market rises, the futures is extinguished at loss, but gains on the call offer a cushion. This is a directional position – profits depend on futures gains or losses.
This is because the futures gain is 1 unit for every favourable 1 unit change in underlying price. But an European option premium changes by a fraction of the underlying’s change. The ratio of derivative price-change to 1 unit change in underlying price is “delta”. Many strategies involve delta. Given option premiums are 1-2 per cent of underlying, the leverage on high delta options is massive. Delta is positive for long calls, negative for long puts. It varies with strike price distance from money, time till expiry, risk-free interest rate, volatility, etc.
A positive delta gains (loses) as the underlying rises (falls). Traders use a rule of thumb to assess delta. If strike is at the money, delta is 0.5 for a call (-0.5 put), in the money delta can rise to 0.9 or higher. Out of money, delta reduces, falling till 0. Near the money strikes are about 0.25 delta.
In a combined position like short futures (delta -1) and long call (delta 0.25), the sum of deltas is negative, indicating the short bias. When deltas cancel out to zero, the position is market-neutral.
Hedge funds like zero-delta positions since a zero-delta position can give positive returns regardless of direction.
For example, a straddle (long call+long put or short call+short put) at the money, is zero-delta. Whatever the price direction, one option gains, the other loses. In fact, the winning option may have rising delta and thus, gain more than the losing option. In practice, zero delta doesn’t always work and close to expiry, delta can break down. So zero-delta positions should always be taken a minimum 15-20 sessions before expiry.
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An almost zero delta position would be a short December Nifty futures position (5870) and three long December 6000 calls. (3x128 premium). This has a downside bias, assuming call delta is 0.25-0.3. Another zero-delta would be long Dec 5900c (181) and long Dec 5800p(95). That’s complicated by massive price differentials.
Assume a short December futures and 3 long December 6000c are taken. If the market drops 100 points, the futures gains 100, and the calls could lose a cumulative 80-90. But the calls can be sold at say, a 50-point downmove (for a total loss of 35-40 points), while the short future is held. If the market moves up 100 points, the calls gain 80-90 and the futures can be extinguished at say, 50 points up. It’s not an easy strategy to implement but it can be useful in choppy markets.
The author is a technical and equity analyst