To DH or Not, That is the Question!

My entire option trading method revolves around the concept of the Delta Hedge (DH) strategy. Any new option trade that reduces the Delta (directional) risk of a current position is technically a DH but my particular strategy is to first buy a single option (Call or Put depending on the expected direction) or a spread (Vertical or Horizontal) and then, when price moves in the expected direction, I’ll either sell a further out of the money (OTM) option or spread or I’ll ‘roll’ the strikes up or down to reduce the Delta risk of the original trade. I know that sounds complicated but it’s actually quite simple after you really understand what’s happening with these ‘adjustments’. The best way to help you understand this concept is for you to see it in action. Directly below you’ll find a theoretical example and then below that I’ve added a real-life trading example so you’ll know that this strategy doesn’t just work in theory. Read on!

The first analysis was done using the ThinkBack feature in ThinkorSwim. Theoretical exercises and discussions should always be viewed with skepticism, especially if the author is not an actual trader. I have personally done trades very similar to this literally thousands of times in the past and I can attest to the accuracy of this analysis. With that said, let’s get to it.

First I’ll look at the most basic option strategy of buying a Call on a bullish breakout. That trade would’ve triggered on 3/26/21 and I chose to buy the SPX Call nearest to 25 Deltas. I often choose options with anywhere from a 20-30 Delta to initiate a new trade. If you’d like more information on how I select the strike of a new trade you’ll find it in this post: https://vegaoptions.com/?p=503

For a swing trade I’d choose an expiration of anywhere from 2 weeks to 3 months or more. Of course the shorter duration options are less expensive but then I need a quicker move to offset the faster time decay (Theta). In this example I chose the June monthly options with 84 days to expiration (DTE) at the time of the first trade.

Simply buying the Jun18 SPX 4150 Call and holding it thru Friday’s close would’ve shown a profit of $7,525 or a 196% return on risk. The directional (Delta) risk of the position was 25.33 at trade initiation on Mar26. As of the close on Apr16, the Delta had increased to 53.12. That level of Delta means that for every 1 point the SPX goes up, the value of that Call will increase by $.53. While that higher Delta is great while price is rising, the opposite of that is the Call will drop by $.53 for every 1 point move down in SPX. A big down day in SPX will be very expensive!

What if, instead of just buying and holding a Call I used a strategy of hedging that Call by selling a further OTM Call for the same or higher price. In this example I used a very simple strategy: buy an initial Call on a bullish breakout and holding until I can sell a $25 further OTM Call for at least as much as I paid for the Call that I bought earlier. That’s it. Pretty simple strategy, right? After I have DH’d the initial trade by selling the OTM Call, I buy a new 20-25 Delta Call in the same Jun expiry. I repeat that process as many times as SPX price allows me too. In a sustained rally that could be repeated many times. If you look closely below you’ll see that, in one of the transactions, I sold a $50 OTM Call instead of $25 OTM to DH a position. That’s because the SPX price rose by so much on that day that I could sell the $50 OTM Call for a greater price then the Call that I bought previously. When price gives me the opportunity to add to my potential profits I usually take it. So here’s the downside to the DH strategy; the profit after using the DH strategy was around $1,500 less than just buying and holding the original Call that was purchased. So why DH?

Below is the breakdown of the effect each trade had on the net cost and the Delta risk of the overall position.

So what benefit did I derive from using the DH strategy? First, the cost of the original trade was $3,840 and if I never DH’d the trade that would remain the cost. By hedging the position the net cost of the position(s) has decreased by over 50% since the original Call was purchased.

The Delta of the original Call was 25.33 on Mar26. Since then SPX has risen by over 200 points which has taken the Delta of the 4150 Call to it’s current value of 55.05. It’s generally not a great strategy to allow the Delta risk to continue to rise as the SPX price rises since the likelihood and potential size of a pullback increases. By DH’ing the position the Delta risk would currently be 18.55 or almost 2 points less than the original trade!

Below is what the current risk profile would look like on that long 4150 Call. The current profit looks great but as the price of SPX continues to rise there is always the likelihood that price will see either a pullback in the uptrend or potentially a reversal from uptrend to downtrend. On the risk profile I’m showing the profit at the current SPX price as well as what the estimated profit would be on a decline of 2.5% and 5%. With no hedge in place the profits will quickly dissipate on that size of decline. That can happen in just 1-2 trading days.

Below is the risk profile of the position if I decided to DH the position. The purchase of the 4375 Call on Apr15 isn’t shown as I want this risk profile to reflect the trader who thinks ‘this current SPX move is so extended that I’m worried about a drop in price so I’d like to reduce that risk and just hold a DH’d position for now’.

Here’s how the position’s open profits compare based on the buy and hold of the original 4150 Call vs. the DH’d position. At the current SPX price I’m giving up around $1,500 in profits but notice that the DH’d position is actually quite a bit more profitable if SPX drops by 2.5% or more.

Below I add the time factor to the risk profiles. In this example I show the estimated profit/loss levels as if the current date was May15. As we all know time has a very large effect on the value of options. This risk profile shows the un-hedged long Calls.

The risk profile below shows the Delta Hedged position estimated as of May15.

Here’s how the position’s open profits compare based on the buy and hold of the original 4150 Call vs. the DH’d position estimated as of May15 . At the current SPX price I’d be more profitable with the DH’d position and the profit gap widens in favor of the DH’d position if SPX drops by 2.5% or more. In fact, a 5% drop in SPX by May15 would leave the long Calls with a large loss while the DH’d position would have a 75% return on the net risk.

	Long Calls	DH’d Calls
Current SPX Price	+$5,115	+$5,301
-2.5%	+$193	+$2,803
-5%	-$2,436	+$1,267

So that was the theoretical example. Below is the list of the actual trades that I made this past week on 3/3/22 and 3/4/22. First step was buying a SPX Put Diagonal spread because of a bearish setup on the chart. I bought a 20-lot Mar11/Mar14 SPX 4300/4250 Put Diagonal spread for $15.85. That was about 60% of a full-size position. I’ll often initiate a trade with 50%-75% of full-size and then add the remaining size if price moves in the expected direction and I’m not stopped out. In this case price did indeed move in the expected direction and so I bought another 10-lot of the same position. Price continued to move lower and so my attention then shifted to DH’ing the position to reduce the position’s directional risk and to substantially reduce my initial risk. Below is the list of all three transaction made in the open position. Notice how I only carried the full risk of the position for 24 hours before being able to reduce my initial risk by over 95%!

Below is what the current risk profile looks like. The position has a very small amount of directional risk and is loaded with positive Theta. I’ll likely hold onto this position into Friday’s expiry. What if I get another chart setup but this time a bullish signal? Shouldn’t I close this out? If I do get a bullish signal I’ll be able to add a new trade that is long Delta instead of closing this one out. This is great downside (cheap) insurance that would allow me to take a sizeable long Delta position if the chart indicates a potential rally. That way I’d have two separate positions that would effectively be hedging each other’s risk. Make sense?

It’s clear what the cost and benefits are of using the Delta Hedge strategy. In a scenario where SPX is in a relentless march higher in price the buy and hold long Call strategy performs best. That is, until price reverses which it will inevitably do at some point. The buy and hold strategy is a bit like playing with fire. To make consistently profitable trades over various trading environments, it’s been my experience that there’s no substitute for a strategy that reduces portfolio risk as price and time progress.

Questions or comments? You can reach my on the @VegaOptions twitter feed.