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 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.
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
When you hedge delta of a call option, it means you may have to short sell underlying stock or sell an option to offset the risk pertaining to delta. Hedging by short selling stock would mean shorting of stock equivalent to the delta at a particular price. If one call option of ABC stock has 50 per cent delta, the trader would have to hedge by shorting ABC stock’s 50 shares.
Delta is ever-changing because there are constant changes in the price of the underlying or time leading up to expiration. Then gamma comes into the picture. While delta is a measure of an option price’s sensitivity to price changes in the asset underlying, gamma moves to the next level wherein it measures the sensitivity of delta changes vis-a-vis changes in price of the stock underlying. In other words, gamma is the rate at which delta changes for each one-point movement in the underlying price.
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.