Delta Neutral Call Option Writing

Advanced Call Writing Strategies

Delta Neutral Call Writing

Much has been written about the popular covered call writing strategy, where an investor will purchase 100 shares of a stock or an ETF and sell one call option for some income and partial downside protection. The term covered call means that for every option you sell that option contract is covered by 100 shares of the underlying investment.

Advanced option traders will be familiar with the term delta neutral. For those readers who are not familiar, the term means that your position is delta neutral, it has no market directional bias, in other words the position is neutral to market movement.  So, if we buy 100 shares of XYZ stock, that position alone will have a delta of 100, now if we sell an at the money call with a delta of 50, because we are short the call it will have a negative delta, so the net position delta will be 50, 100 deltas for the 100 shares of XYZ stock and -50 deltas for the short XYZ call. This is how your typical covered call position works. If you were to sell an out of the money call with a delta of 25 your net position delta would be 75, in other words the total position would behave like 75 shares of the underlying instead of 100.

Now, if we want to create a market neutral position, we’ll sell enough calls so that the net position is delta neutral. So, if we buy 100 shares of XYZ again we could sell two 50 delta at the money calls, three 33 delta out of the money calls, or four 25 delta out of the money calls and so on. If the net position delta is at or near zero, your position will not have directional risk as long as it remains delta neutral. Then you can earn the theta or the decay from the short options. You don’t have to sell the options at just one strike price, either. For example you could sell one at the money 5o delta call and two out of the money 25 delta calls.

Once a position is established, the delta will change by the rate of the gamma, and adjustments will have to be made to remain delta neutral. You can adjust the shares of stock you own, sell more calls, or buy some calls back to make the delta neutral adjustment.

As with any strategy there are risks, the underlying can drop rapidly before you can adjust and you can experience a loss. Since you have uncovered short calls, if the underlying explodes upward rapidly you can also experience a substantial loss. Stocks that have high volatility or may be potential takeover targets should be avoided. Mega cap stocks can be good candidates or broad based index ETFs can be good candidates for a delta neutral strategy. Indexes can rise and fall rapidly, but they have never dropped all the way to zero like individual equities can or explode upwards the stocks getting taken over can.

Looking at some current prices as of this writing, the SPY is at $131.82 and the Feb 135 calls are 21 days from expiration. The Feb 135 calls sell for $0.61 and have a delta of 24. You could sell 4 of those calls against a 100 share position of SPY and take in $2.44 in premium, the theta is -0.03 so you’d be getting $12 per day in decay. You could make delta neutral adjustments as time goes by on a regular basis, but you wouldn’t have to worry about loss unless the SPY rises to above 135 by expiration. This is not a recommendation for the above SPY trade, I like using some real numbers for illustrative purposes, this is a strategy for sophisticated investors who understand the risks and are familiar with options and making delta neutral adjustments.


About sellacalloption

Author, Radio Show Host and Portfolio manager and chief option strategist for IWC Asset Management.

Posted on January 28, 2012, in Covered calls, Neutral Income Strategies and tagged , . Bookmark the permalink. 1 Comment.

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