Analyzing Directional Risk: Naked vs. Defined
Analyzing Directional Risk: Naked vs. Defined
By:Kai Zeng
Here’s how to manage delta with spread strategies, while improving stability with spread options
Switching from a risk-undefined (naked) option trade to a risk-defined strategy helps investors reduce the capital needed to maintain the position and decreases the maximum risk. Additionally, it diminishes directional risk, also known as delta. A smaller delta means the investment is affected less by changes in the stock price, resulting in slower profit or loss changes.
For instance, imagine selling a naked call option on Amazon (AMZN). If Amazon's stock price declines, you could face significant potential losses that are magnified by the delta value. However, converting this to a spread, such as a vertical spread, provides better control over delta exposure, reducing the impact of market volatility on your investment.
Naked options and spread strategies have different delta sensitivities. Generally, the tighter the spread, the lower the delta.
This difference becomes crucial when the market falls sharply and implied volatility (IV) increases quickly. In such scenarios, naked positions are more prone to delta expansion compared to spreads.
Consider the 2008 market crash as an example. During that period, naked positions showed a significant increase in delta, while spreads experienced less dramatic changes. This highlights the importance of using spreads to maintain more manageable delta levels, especially in volatile markets.
To understand how delta exposure changes over a standard 45-day trading cycle, compare risk-defined and undefined positions. A study that compared a 45-day, 20-delta put on the SPDR S&P 500 ETF Trust (SPY) with a 20-delta/$5 wide put spread found distinct patterns emerged.
In winning trades, the delta expansion and differences between these strategies were relatively small, as the positions were primarily out-of-the-money (OTM) when profitable.
However, in losing trades, naked puts showed quicker delta expansion than spreads. These in-the-money (ITM) positions represent higher risk if not proactively managed. Closing naked positions at 21 days to expiration (DTE) can significantly reduce directional risk by more than 50%.
Key Takeaways:
Small Delta Difference in Winning Trades: The delta exposure difference between risk undefined and defined options is minimal for winning positions.
Higher Risk in Losing Positions: Undefined positions, such as short puts, experience quicker delta expansion in losing trades, increasing risk more than spreads.
Proactive Management is Crucial: Actively managing undefined positions, such as closing them at 21 DTE, can greatly lower directional risk.
By understanding and using risk-defined strategies, investors can create more balanced and secure portfolios, effectively navigating market volatility.
Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1
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