Traditional long-only portfolio management theories advocated diversification as the primary risk-management strategy. The volatility or standard deviation of an asset's historical return is widely used to quantify risk. MPT entails locating the optimal point along the efficient frontier determining the portfolio asset weighting matrix that carries the least risk given an expected return. Although having anything that is not perfectly linked with each other would assist minimize portfolio risk, growing positive correlations between formerly negatively-correlated assets have created MPT practitioners challenges on the asset level as the diversification advantage has diminished. Delta neutral strategy has come into the scene as an alternative tactic. The purpose of this article is to discuss the basics of delta and offer a detailed analysis of the numerous delta neutral techniques available to traders and investors in the crypto markets.<h2>The importance of portfolio diversification</h2>The basic premise of asset-level diversification is that investors are asset owners — a traditional "long-only" attitude. However, holding assets is only one investment strategy; adopting more strategies than just owning assets is what we call strategy-level diversity.To provide an illustration, strategy-level investment is something that the world's greatest sovereign wealth funds (SWF), pension funds, and insurance companies have been doing for decades. A typical SWF would most likely invest in asset-owning strategies as well as alternative strategies, which can be outsourced to specialist hedge funds. Some hedge funds, for example, specialize in conducting "black-swan strategies," which are effectively rolling bets on tail occurrences. Because asset-owning strategies and non-asset-owning strategies are intended to generate returns from distinct risk premia, they naturally have smaller correlations with one another. This strategy-level diversification greatly lowers the projected volatility of the total portfolio.The most touted, contested, and questioned diversification tactics in TradFi, CeFi, and DeFi are probably delta neutral ones. Unlike an asset-owning strategy without hedges, which is considered "delta-one," a delta neutral strategy is said to have an investment return that is agnostic of the asset's price return.The realm of TradFi is no stranger to delta neutral techniques. Arbitrageurs are typically net flat on the underlying asset they are arbitraging, but they are affected by other obstacles like different timings, expenses, mispricing due to technical issues, and so on. For instance: arbitraging FX pairs or shares of the same firms listed on different exchanges.Some delta-neutral approaches have already failed, as Long Term Capital Management proved to the world when their "statistical arbitrage" trades were struck by mathematically impossible tail occurrences and subsequently collapsed.<h2>What are delta and delta neutral?</h2>Simply said, delta is the amount by which the value of a position would change if the underlying asset moved $1. In mathematics, delta is equal to dP/dS, where P is the position value of the investor and S is the spot market value of the underlying asset. Although derivatives, notably options, are where the idea of delta originated, it may be used to describe practically any financial product.Delta may be thought of as the directional exposure to the price return of a certain underlying asset. Simply put, directional exposure is the risk of loss brought on by exposure to the direction of the asset. As briefly indicated above, short positions in linear instruments, such as futures, have a delta of -1 whereas long positions in asset classes have a delta of one.With an example, let's take a deeper look at delta:<ul><li>Bob's portfolio includes one Ethereum (ETH), which she purchased for $2,000 at the time.</li><li>Bob's portfolio has an ETH delta of 1. This indicates that if ETH falls by $1, Bob will experience an unrealized loss of $1.</li><li>If ETH rises by $1, Bob will make a $1 unrealized profit.</li></ul>Delta neutral implies that one's portfolio has zero-sum deltas to a particular underlying asset or benchmark (dP/dS = 0). It should be noted that delta neutral is always a relative term that depends on the S used in dP/dS. A portfolio with zero ETH delta, for example, does not always have zero BTC delta as well.Here's an easy example:<ul><li>Consider a portfolio with one spot ETH and one short ETH perps position:</li><li>The ETH delta for one spot ETH is 1, while the ETH delta for one short ETH perp is -1.</li><li>Taking into account funding expenses and price fluctuations, the overall ETH delta for the portfolio is 0.</li></ul><h2>Delta neutral strategies</h2><h3>Spot arbitrage</h3><h4>CEX spot arbitrage</h4>Cross-exchange arbitrage, as previously said, is one of the most fundamental techniques to produce delta neutral income since it includes concurrently buying and selling on various exchanges.CEX spot arbitrage comprises finding price disparities between CEXs such as Binance and Bybit on a certain cryptocurrency and trading the gap until it vanishes or becomes so little that the cost of trading outweighs the possible earnings. Arbitrage opportunities arise since some CEXs are bigger than others and have greater trading volumes. As a result, demand and supply on one CEX may fluctuate dramatically from another, affecting pricing.In fact, arbitrageurs may face friction that reduces arbitrage gains, especially when attempting to move tokens acquired on one exchange to another for sale. One strategy is to be long on one exchange while starting a short position on the other, then wait for the two exchanges to converge. Due to the fact that two positions are opened, the arbitrageur must keep double the collateral/capital.As more sophisticated players with speedier technology enter the market, spot arbitrage possibilities have become increasingly difficult to locate. Investors may still discover arbitrage possibilities by looking at less popular cryptocurrencies, which often have a bigger price differential due to their low order book volume and depth.<img src="https://cdn.builder.news/news/11ed75450d806304a8e6023f659fee92.jpg" alt="cex spot arbitrage" title="cex spot arbitrage" width="600" height="182" class="lykafe0">Source: Substack<h4>DEX spot arbitrage</h4>DEX spot arbitrage is comparable to CEX spot arbitrage in that the price difference between DEXs is captured. The identical methods that were outlined in the CEX spot arbitrage section can also be used to DEXs. However, unlike CEXs, DEX arbitrageurs can trade without execution risk by developing a smart contract or a MEV bot that executes both legs of the deal atomically. Atomicity assures that all activities inside a transaction are legitimate and capable of being accepted. Because there is no time delay between purchasing, transferring, and selling, this dramatically decreases execution risk.Furthermore, arbitrageurs are not required to install fiber-optic cables across the country, as sophisticated arbitrage funds do to minimize latency. This is because all transactions are eventually subject to the blockchain's block timing, putting all traders in the same start position.DEX arbitrageurs, on the other hand, are still governed by the rules of the miners and validators since these blocks can be re-arranged and re-ordered in terms of the priority of being processed. Furthermore, because the transactions are accessible to the parties who confirm the blocks, DEX arbitrageurs are subject to front-running. When transactions are posted to the blockchain, validators and mines might utilize the data to execute the deal ahead of the arbitrageur.<h3>Funding arbitrage</h3><h4>Spot vs Future spread</h4>The Cash and Carry trade is a tried and true method in both the traditional and crypto markets. The strategy takes use of futures' term structure by involving a long/short pair of spot and futures contracts. As the futures near expiration, their prices approach the spot price, and the difference between the current and future prices can be grabbed as delta neutral gain.Futures contracts bind the parties involved to purchase or sell the underlying asset at a preset price for delivery at a future date. There are several BTC futures contracts available, each with a distinct expiry date. Prices between spot and futures, as well as between different-dated futures, may or may not be equal at any one moment. Such pricing disparities result from the costs and benefits of holding spot and future assets.<h4>Spot vs Perps funding</h4><a href="https://www.builder.news/crypto-insights/a-deep-dive-into-perpetual-futures-KMFmm" alt="A Deep Dive Into Perpetual Futures" title="A Deep Dive Into Perpetual Futures" target="_blank" rel="nofollow" class="">Perpetuals</a> are used in another version of the Cash &amp; Carry trade. Perpetuals are essentially futures contracts with no expiration date. Unlike futures, which automatically represent in-kind financing costs through term structures, perpetuals enforce an actual funding cash flow since they lack an expiry date that pushes spot and futures prices to converge. Depending on the exchange, funding cash flow trades hands between long and short open interests (OI) on an hourly or 8-hourly basis.The funding rate for perpetuals is primarily decided by the difference between the trading and "mark" prices, while other factors such as the financing rate for leverage also play a role.A positive funding rate, in which long OI pays short OI, indicates that the perpetual is trading above its exchange-determined "mark" price, and typically signifies that long OI outweighed short OI in the preceding funding cycle.Keeping this in mind, traders may efficiently capture the funding rate while being delta neutral.Similar to spot and futures trading:<ul><li>After every eight hours passes, the funding rate of BTC-PERP is 0.01%:</li><li>Longs must pay shorts to maintain their position.</li><li>A trader can sell BTC-PERP and buy BTC-USD in the same amount.</li><li>The trader can hold the position open as long as the funding rate remains over the targeted level for a substantial profit.</li></ul>There are dapps that enable automated spot-perps funding<img src="https://cdn.builder.news/news/11ed75450d806870a8e6023f659fee92.jpg" alt="friktion delta neutral options" title="friktion delta neutral options" width="600" height="268" class="lykafe1">Source: Friktion<h3>Delta neutral volatility</h3>Because options use greeks other than delta, they have evolved into natural tools for expressing opinions on non-delta risk premia. Among the most prevalent greeks of options are<blockquote class="">Delta: dP/dS, where P is the option price and S is the spot price.d(Delta)/dS = GammaVega is defined as dP/d(IV), where IV is the implied volatility.Theta = dP/dT, where T is the time.Rho is defined as dP/dR, where R is the interest/discount rate.</blockquote>If one decides to preserve residual delta, volatility techniques are not always delta neutral. In this section, we will concentrate on dynamically delta-hedged structures that are pure volatility gambles. Volatility gambling generally includes exposure to gamma, vega, and theta.It is important to distinguish between realized volatility (RV) and implied volatility (IV) (IV). RV is downward statistics defined simply as the confidence interval of a certain historical time period's spot price. As the name implies, the value cannot be determined until the time period has elapsed. IV denotes the market's pricing of predicted forward-looking volatility, which is deducted from option prices using option pricing models, most commonly Back-Scholes.Empirical evidence suggests that gamma is a gamble on RV while vega is a bet on IV. The latter is obvious since vega is, by definition, the derivative of option price on IV shift. However, the rationale for the former is less obvious, as will be demonstrated later.<h4>Short volatility</h4>Short volatility is a common way to get profit. A few risk premia can be ascribed to the revenue obtained.To begin, yield may be generated from the variance risk premium (VRP), which is the difference between IV and RV. Because traditional long-only investors are generally price-insensitive when purchasing options to hedge their portfolio, IV has historically been greater than RV. The VRP harvesting technique is implemented cleanly using a delta-hedged schedule spread, which results in long gamma (RV) / short vega (IV) exposure levels.Second, time decay or positive theta generates profits for overtly short volatility strategies. As an option nearing expiry, the underlying has less time to move in the money (which provides intrinsic value), leading options to lose price as time passes.Because short volatility implies selling options, the strategy gains from a decrease in the time value embedded.Delta neutral short-volatility option structures can have several shapes. The most basic is an at-the-money (ATM) straddle, which entails simultaneously selling ATM calls and puts.According to the normal distribution, ATM options have a delta of 0.5 because they have an equal chance of being in-the-money (ITM) or out-of-the-money (OTM) at expiry. However, in practice, asset returns do not follow a normal distribution. For example, in the early days of cryptocurrency, returns were substantially asymmetric to the upside, skewing the real-world likelihood. As a result, an ATM call may not have a delta of 0.5. (or -0.5 for puts).<h4>Long volatility</h4>Long vol is a negative carry structure by itself, in contrast to short vol, which is a sustainable income-generating strategy because of VRP and theta decay. However, as the delta grows when the spot increases, dynamic hedgers instinctively buy low and sell high on the underlying asset to preserve delta neutrality. This is made possible by the positive gamma exposure connected to long options holdings. The whole structure is profitable as long as the realized dynamic hedging P&amp;L exceeds the theta decay paid by the long-vol position.Gamma is seen as a bet for RV since it offers the chance to benefit from the underlying asset's movement or volatility; long gamma is simply a gamble that the RV will outperform theta decay.Below is Dopex long straddle vault<img src="https://cdn.builder.news/news/11ed75450d8076d7a8e6023f659fee92.jpg" alt="dopex long straddle vault" title="dopex long straddle vault" width="600" height="254" class="lykafe2">Source: DopexConclusionIn a nutshell, delta neutral strategies can assist investors in reducing the connection between typical asset-owning investments and delivering returns that are not affected by asset price changes. It enables investors to obtain exposure to alternative risk premia that deliver greater Sharpe ratio returns.&nbsp;This strategy is extremely useful in a bear market when the opportunity to earn from the spot tactic is very low and the risk of employing perps is pretty high.<div class="pr-block-special">Disclaimer: This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.</div>

A portfolio approach known as "delta neutral" employs numerous holdings with a balance of positive and negative deltas so that the assets' combined delta is zero.

Delta neutral strategy: a powerful tactic to survive in bear market