Delta Hedging For Fun and Profit

October 19, 2020 by Paul

Bottom line: on 10/19/2020 I began the trading day with $0 of risk and no asset value in a SPX
position. At the end of the trading day I had $0 of risk and 1 asset that had the potential to be
worth as much as $25 in a SPX position.

I came into the today’s trading day reasonably flat Deltas (little directional risk) because all of the
indexes had formed Doji’s on the weekly chart last week which isn’t a great time to have a strong
directional bias.

As this morning progressed I became more bearish due to the price action. Less than 2 hours into
trading I tweeted to the subscribers that “the ‘nuance’ in this morning’s trading leaves me with
the impression that SPY is heading lower towards last week’s low instead of higher. Bulls dropped
the ball this morning.”

A short time later I followed with this tweet. “as SPY price continues to gain acceptance near the
lows of the day it increases the likelihood that price is going to breakdown.

That’s what ‘should’ happen. If what should happen doesn’t, I’ll exit my bearish position.
Otherwise, still targeting last week’s low.”
Due to the price weakness shown on the charts, I shorted some SPX Deltas early by buying a Put
Diagonal spread and I hedged those Deltas just prior to the close. What does Delta hedging
accomplish? It reduces cost and, at the same time, directional risk.

These 3 transactions were all from today. I bought a $25 wide Put Diagonal in the morning for a
cost of $14.50 to establish a bearish position and then, about 3 hours later, rolled the long Put
down by $15. That was the first reduction in Delta risk and position cost. That took my net cost
down from the original $14.50 to just $6.00. As SPX continued to drop into the late afternoon I
decided to roll the long Put down another $10 to turn the position into a Calendar spread.

After those 2 adjustments to the original position my net cost was now $0. A zero cost Calendar
doesn’t have much Delta or Gamma risk but it can have a large amount of additional potential
profit as you can see from the risk profile below.

Now the plan is to just let some more time pass and see if SPX stays in the vicinity of 3450 into
the Friday, Oct23 expiry.
Friday, 10/24/2020 Update: As SPX traded between 3440 and 3465 on expiration Friday the
Calendar spread that I owned increased in value throughout the day. If SPX is trading within
about .5% of the Calendar’s strike price I will typically hold onto the position and exit it late in the
trading day.

If I close it out too early I don’t take full advantage of the position’s Theta.

I collected a $12.75 Credit for selling the Calendar spread to exit the position. That represents an
88% return on the original $14.50 cost of the position. Remember however that I only had that
amount of risk exposure for a little more than 3 hours. I did not carry that risk overnight so, from
a risk standpoint, this position had the advantage of being a day trade.

From a profit perspective, this position had the advantage of being a swing trade.
Once I had eliminated the risk in the SPX position then I was able to add another position to my
portfolio without exceeding the original $14.50 cost.

But, instead of 1 position with that amount of risk I’d now have 2. Let’s say that I’m able to Delta
hedge that position as well. Now I can add a 3rd position for a total of $14.50 in risk. You can see
how the leverage of having multiple positions with just the amount of 1 position’s risk/cost can
potentially increase a portfolio’s value.

So this is what Delta hedging can bring to an options portfolio. Let me know if you have
comments or questions.