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Tales of a Technician: Delta Limits

May 24, 2017

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Tomas posed a question in the clubhouse that warrants further investigation.

“On Delta trading, what would be a reasonable delta limit for my portfolio?”

Let’s hop to it. First, some background information. Delta is the greek that measures our directional exposure. So the higher your delta, the more exposure you have. And while a large delta is lovely when the market is moving favorably, it’s terribly painful when the market sours.

To protect their capital (and sanity), professional traders develop limits as to how much exposure they’re willing to have. Delta limits, in other words. And we’re not talking about the delta of one position. We’re referencing the portfolio delta. Good options brokers will tell you your portfolio delta (usually beta weighted to SPY). A discussion on portfolio beta-weighted deltas can quickly turn complex, so I’m going to try to keep today’s comments on the simple side.

Let’s say your portfolio delta is 65. That means the net directional exposure of your entire account is the equivalent of 65 shares of SPY. Basically, you would lose $65 per $1 drop in the SPY. To determine if this is okay you need to model how much you could lose if the SPY stages a significant decline. Suppose we agree that a good rule of thumb for a “significant drop” is two weekly ATRs. Since SPY has a weekly ATR of $3.62, we’re talking about a $7.24 move.

To determine the total amount of loss inflicted by this adverse move, simply multiply the 65 deltas x 7.24. The estimated loss would be $470.

Now that you have an idea of what the loss would be you can make an informed decision on whether 65 delta is too much exposure. Can your portfolio stomach a $470 loss? What is that as a percentage of the total account?

Identifying the right number depends on two primary factors: account size and willing loss.

Account Size

The larger your account size, the higher your delta limit can be. Obviously, someone with a $100K account can take more risk (dollar-wise) than one with a $10K account. Maybe the trader swinging a $100K account has a delta limit of -300 to +300.  And the one with the $10K account has a limit of +40 to -40.

Willing Loss

The second factor is how much of the capital you’re willing to have at risk at any given time. Let’s use the $100k account to illustrate. And, we’ll still assume a $7.24 move in the market is what we want to model as a “significant adverse move.” If you had a delta of 300 and the market fell $7.24, you would lose approximately $2,172. That’s only like 2% of a $100K account. But maybe you’re super conservative, and that’s the amount you’re comfortable with.

Another trader may decide they’re willing to have 5% of the account at risk. Their delta limit would be larger, like -700 to +700.

It will take some trial and error to find the right size for yourself. If you haven’t done it yet, find out where your broker displays the portfolio delta and begin to track it. Pay attention to how quickly you make or lose money based on how high or low the delta is. Here’s a pair of screenshots showing where to locate the beta-weighted portfolio delta for ThinkorSwim and Tastyworks


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4 Replies to “Tales of a Technician: Delta Limits”

  1. STEWGILGIS says:

    Very helpful explanation.
    Thank you.

  2. BRUNOSILVINO says:

    Great read.. thx Tyler!

  3. CHARLESZELEWSKI says:

    Great review; very timely with the markets at all time highs. A breakdown could occur anytime; and it’s really helpful to know what effect that can have on the entire portfolio.
    My thanks to Tomas for posing the question.
    Thanks for including TastyWorks, I now have account with both TOS/TDA and TastyWorks. I’ll probably switch over entirely to TastyWorks when they finish adding a few more bells and whistles. I really like the way they present the view of an option to trade with bubble above and below the line, it makes it easy to see what’s what; and it’s exactly the same way I was doing it on paper.
    Again, thanks for all the hard work you put into Tackle Trading and the Elite courses. (BTW I really enjoyed the way your wife sent in your alarm clock at the end of the Cash Flow Club)

  4. CYNTHIABLACKWELL says:

    Thanks Tyler. Valuable information.

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