But First, an Explanation
Before I get started speaking about Delta I want to correlate what I’m about to talk about to another aspect of life. Most of us learned to drive when were about 15 or 16 years old. We get the basics, we get formal education, and we learn mainly from our parents how to be good, defensive drivers. Most parents do not teach and do not know how to teach their children to be racecar drivers. However, we can all agree that racecar drivers are probably a cut above the average driver from the standpoint of understanding the dynamics and physics of speed. If a parent is a racecar driver, the child that he’s teaching most likely will have a better understanding of the dynamics that the parent knows. The discussion in this article is really designed to learn the best tactics that a racecar driver will know and apply it to every day driving. Replace that with stocks and options and you’ll understand my goal in explaining this to the average value investor.
What is Delta? A little-known concept know by retirees, those wanting to retire, and value investors is the concept of Delta. Delta is an option Greek that measures the options movement in relation to the price of the stock. Therefore, if an option has a delta of .5, it would move up $0.50 for every one dollar in the stock’s price move.
What is Delta? Why should I be concerned?
Every stock has a Delta of 1.0 for every share you own. So, if you own 100 shares of Apple you have a Delta of 100 and Apple stock. Generally, people investing in their retirement accounts are usually only long stock. When you are invested in long stock alone your portfolio Delta is always long the number of shares you own.
Unfortunately, most people do not know what Delta is nor do they know why they need to understand Delta. In retirement accounts, it is often hard to hedge against a down market with long stock. Many will balance with value plays like consumer staples, energy, or some other hedge against a down market. With a better understanding of Delta you can have a better understanding of what you need to do to protect against a down market.
What is my delta?
As I explained before, every stock has a Delta value of 1.0. You may ask, how you reconcile a Google stock ($GOOG) valued at $1100 in relation to a silver index fund ($SLV) valued at $15. This is where the concept of beta weighting comes in.
Beta weighting is simply the value of a stock in relation to another stock or index. Using the example above, Google has a beta weighting of 1.36, which means Google will move $1.36 for every one dollar move in the $SPX. $SLV on the other hand has a beta weighting of .176, which means again the stock will only move about $0.17 for every one dollar move in the $SPX. The $SPX, or S&P 500 index is one of the more broad indexes. To gauge the overall market against the $SPX seems the most reasonable, especially for a retirement account.
By the Numbers, How to Hedge Delta Risk
probably the easiest way to create a true hedge of Delta risk is to know exactly what your risk is by the use of beta weighting. Not every platform offers beta weighting. Generally, to get beta weighting information you must have an options trading platform. You can use an options trading platform even if you only trade stocks. Two good trading platforms are TD Ameritrade (please click here, as we get a finders fee and you help us produce good content) and TastyWorks (again, click here to help us out). If TastyWorks does not have beta weighting when you read this, they will shortly.
Many people are limited to the account type in Brokerage of their employer. For example, in my retirement account I cannot use either the brokerages listed above. However, do not fear as you can often approximate Delta risk or more simply use some tech simple technical indicators to hedge off that risk. In my retirement account, I will start buying long stocks that are either reverse ETF’s, or long volatility. As of this writing, I prefer $TZA which is an inverse Russell 2000 stock; $SDS, which is an inverse S&P ETF; and $VXX, which is a long volatility product. Please stay away from ultra short products, 3X products, and products that are cash settled. If you don’t know what these are, perhaps stick to the indexes and products mentioned above. When a stock market goes down $TZA will probably out perform in the short term, followed by $VXX. $VXX will outperform at the market bottom. $SDS will most likely hedge against a long-term down move. Be aware all these products do lose money if they’re held too long on an up move. Market timing is almost impossible, so the best way to hedge is to actually hedge. By this, I mean you should buy a small amount of shares of these hedging products when you feel the market is topping. If the market continues to be go up, simply by a few more shares over the days, weeks, and months. Please be careful not to buy too much. I’m suggesting the use of these products as a hedge, not as a directional investment. If you must use these products as a directional investment to the short side, consider using an options strategy, if your Brokerage allows.
The screenshots below compare the same portfolio at the same time with no beta weighting (left) and with beta weighting against the $SPX (right). You can see the extreme difference in looking at the same portfolio through a different lens. When you beta weight your deltas and get close to zero from a portfolio standpoint, you are lowering your directional risk to one side or the other. If the market were to go down and you had positions in the hedge products I mentioned above, you would sell these products when the market bottoms, or what you think is the bottom. If you make 15% – 25% I would recommend edging out or selling your hedge entirely. Remember, bulls make money, bears make money and pigs get slaughtered. If you think the market has further to run down then maybe keep a portion on the table but take the rest off. The beauty of the strategy is you now have your hedged money in cash to invest in long positions that pay dividends or you can write calls against (covered calls).
If you have any questions, please feel free to comment below and I will answer them best I can. In the meantime please also consider using PocketSmith for your accounting. It is the best product I’ve ever seen and want to support them. By clicking on the banner below you support our blog and the information we provide.