Delta hedging is to protect investors against delta risk. Delta is the measure of the price movement of an asset and the corresponding price movement of its derivative. Therefore, Delta hedging involves arranging two or more trades simultaneously that offset the delta risk of an underlying asset.
What is delta hedging?
Delta hedging is a hedging strategy that refers to protecting a trader against the directional risk of an underlying asset’s price movement. Simply put, it hedges an investor against the delta risk of an investment.
Investors use options to reduce or mitigate the delta risk of an investment or a portfolio of investments. The approach aims to achieve a delta neutral position by hedging through options and balancing the portfolio against the directional risk of price movements.
Theoretically, an investor’s risk will be mitigated with delta hedging through offsetting options perfectly matched in opposite delta directions. However, it requires careful management and continuous monitoring to achieve a net-zero delta risk.
What is delta?
Delta is an options greek that measures relative price change in an option that corresponds to the change in an underlying asset. It is the ratio of the change in the price of an asset compared to the price movement in the derivative of that asset.
Suppose a stock XYZ has a delta of 0.7. It means that when XYZ’s stock price changes by $1, the option price will increase by $0.70.
Delta value for call options always ranges from 0 to +1. Similarly, the delta value for put options always ranges from 0 to –1. It means the delta value can range depending mostly if it is a call or a put.
How does delta hedging work?
Delta hedging aims to achieve a delta neutral position using an options strategy. It largely depends on the behavior of the delta.
The delta depends on whether an option is:
- In-the-money (profitable)
- At-the-money (at the same price as the strike price)
- Out-of-money (not profitable)
Traders can predict the delta of call and put options that can also help them devise delta hedging strategies.
It’s important to understand the net position of the options. For instance, if a call option has a delta of 0.50, it is said to be at the money. Similarly, if a call option has a delta of 0.70, it is said to be in the money.
In theory, as the asset price moves in the direction of the option and strike price you selected, the delta will be higher if it is a call or lower if it is a put. This simply reflects how option prices can increase in value, as the underlying asset’s price moves in the direction you predicted.
Neutralizing Delta Risk
You can hedge against delta risk by arranging two options with the same delta value but in the opposite directions.
A delta neutral position can be achieved when the total delta of value becomes zero. It means the directional price movement of an underlying asset will have a net-zero effect.
Delta hedging example
An investor invests in a stock XYZ. The XYZ stock has a put option with a delta of –0.50. It means the put option is at the money. The investor can offset the delta risk of the put option by purchasing a call option that has a delta of +0.50. The call option with +0.50 is also at the money.
This way, the total delta risk for the investor’s investment in XYZ stock will have a delta neutral position.
Investors can also use the same approach of delta hedging by using stocks instead of options.
For example, an investor has a call option with a delta of 0.60. The actual delta will be 60 because one call option represents 100 shares.
The investor can short 60 shares of the same stock to neutralize the delta risk of the long call option. The approach works similarly to choosing two options having the same delta risk in different directions.
Advantages and disadvantages of delta hedging
Delta hedging offers some benefits and limitations to traders.
Delta hedging may seem a complex strategy but it is very useful. It protects investors from the direction price risk, and it is a useful strategy when market prices are moving consistently.
It can also be used for balancing their portfolio investments, and to protect profits from an option position in the short term.
Investors need to monitor their portfolio delta risk continuously. It requires consistent monitoring to manage delta risk through the delta hedging method.
Since there are numerous transactions to neutralize delta, the transaction costs may increase substantially.
Investors may over hedge using delta hedging methods. It means they may lose profits from the upside risk available otherwise.
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