What Is Delta Hedging?

Trading involves several strategies and one of them is delta hedging. If you are wondering what is delta hedging, it is a strategy in options that hedges or lowers the risk linked with an asset’s price movement.

Delta hedging strategy is used in options to ensure that the risk is cut by setting up short and long positions for the underlying asset in question. This way, the risk in a directional sense is cut down and a state of neutrality is achieved. In a delta neutral situation, any change in the price of the underlying stock or asset will not make an impact on the price of the option.

Essentially, the aim of the delta hedging strategy is to cut or minimise risks that come with price movements of an underlying asset.

What is delta?

Now that you know what is delta hedging, you may wonder what delta itself is all about. Delta is the rate at which premium changes on the basis of the underlying asset’s movement directionally. In options, delta is a measure of how sensitive the price of a particular option is to changes in the underlying asset’s market price. The price of the option referred to here is its intrinsic value, i.e. the value of the option if it were executed at this point in time.

Call options have delta in the positive while put options tend to have delta in the negative. Delta is the range of 0 to 1 in call options while it is 0 to -1 in put options.

Another factor to consider is that the delta of an in-the-money (ITM) option will be over 0.5 while an at-the-money (ATM) option will have a delta of 0.5. An out-of-money (OTM) option will have a delta of less than 0.5. With change in price of the underlying a given option could move from OTM and then to ATM before touching ITM, or vice-versa.

How Does Delta Hedging Work?

Delta hedging works by maintaining a delta-neutral position, where the combined delta of an options portfolio and the underlying assets equals zero. Traders achieve this by balancing long and short positions in options and the underlying stock. For example, if a trader holds call options with a delta of 0.5, they can sell enough shares of the underlying stock to offset the delta, creating a neutral position. This way, price changes in the underlying stock do not affect the overall value of the portfolio. Adjustments are made continuously as delta values change with fluctuations in the underlying asset’s price and time to expiration. The strategy helps manage risk and stabilise returns despite market movements.

How Do Traders Use Delta for Hedging?

A delta hedging example may help for a better understanding of what is delta hedging and also how it is used. Option positions can be hedged by making use of shares of the stock underlying. One share of a stock will have a delta of 1 because the stock’s value increases by Rs 1 with every Rs 1 rise in the stock.

Suppose a trader holds a call option with 0.5. If the stock’s lot has 1000 shares, the trader can hedge one lot of the call option by way of selling 650 shares of that stock.

A key point to note is that traders don’t necessarily use the same scale to measure delta in options. The 0 to 1 scale and 0 to 100 scale are both used by traders. So, 0.40 delta value on one scale is 40 in the other, i.e. 0 to 100 scale.

Advantages and Disadvantages of Delta Hedging

Advantages:

• Risk Reduction: Delta hedging helps in reducing the risk associated with the price movements of the underlying asset, providing a more stable investment.
• Neutralises Market Movements: By maintaining a delta-neutral position, it minimises the impact of price changes in the underlying asset on the portfolio.
• Profit Protection: It safeguards profits by offsetting the risk of adverse price movements, thus protecting the trader’s gains.
• Flexibility: Traders can adjust their positions dynamically as market conditions change, allowing for responsive risk management.
• Improves Predictability: Delta hedging provides a more predictable outcome by stabilising returns and reducing volatility in the portfolio.

Disadvantages:

• Complexity: The strategy can be complex and requires continuous monitoring and adjustment, which can be challenging for novice traders.
• Transaction Costs: Frequent adjustments to maintain delta neutrality can lead to high transaction costs, which can erode profits.
• Gamma Risk: Delta hedging exposes traders to gamma risk, where changes in delta due to the underlying asset’s price movement can complicate the hedging process.
• Short-Term Focus: The need for constant adjustments may lead to a short-term focus, diverting attention from long-term investment goals.
• Market Conditions: In highly volatile markets, maintaining a delta-neutral position can be difficult and less effective, leading to potential losses.
• Resource Intensive: Requires significant resources, including time, effort, and technology, to implement and maintain effectively.

Here is one more delta hedging example for a better grip on delta hedging as a strategy.

Suppose a trader has 20 call options on ABC, wherein the option delta is 0.25. This means you have 20 x 0.25 x 100 shares or 500 shares in ABC. If you were to take up delta hedging on this position by way of shares would mean you have to sell 500 shares so as to offset call options.

Similarly, if you have 25 put options on JKL, where the delta of the option is 0.75, it means your position is short by 1875 shares (25 x -0.75 x 100). The delta hedging strategy that comes into play here is for you to buy 1875 shares of JKL so that you make up.

Factors to Keep in Mind While Hedging Delta

• Short Selling: To hedge a call option’s delta, you might need to short-sell the underlying stock. For instance, if a call option of ABC stock has a 50% delta, shorting 50 shares of ABC stock would be necessary.
• Delta Adjustments: Delta values are dynamic, changing with the underlying asset’s price and as time progresses toward expiration.
• Gamma Sensitivity: Delta’s changes are influenced by gamma, which measures the sensitivity of delta to price movements in the underlying asset.
• Gamma Impact: Gamma reflects how much delta shifts for each one-point change in the underlying stock’s price.
• Continuous Monitoring: Constant adjustments are essential to maintain a delta-neutral position as market conditions and deltas fluctuate.
• Strategic Balance: Effective delta hedging requires balancing the underlying asset’s positions and options to achieve and maintain neutrality.
• Transaction Costs: Frequent adjustments can lead to higher transaction costs, impacting overall profitability.
• Complexity: Managing delta and gamma can be complex and requires a thorough understanding of options pricing and market dynamics.

Conclusion

Now that you know what is delta hedging, you also know that it is an effective strategy to lower or cut risks that come with changes in the price of an option. Delta hedging strategy also helps traders protect their profits arising from a stock/option.

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