Delta hedging is the process of reducing exposure to potential loss resulting from price fluctuations in the security underlying his or her options positions by bringing the delta – or price relationship between options and their underlying securities – of a portfolio to zero, or closer to it (a position called ‘delta neutral’ or ‘delta hedged’). This is accomplished by purchasing financial instruments which counterbalance each other's exposure to price fluctuations, often adding short or long positions in other options or the underlying securities themselves.
Delta is a ratio which measures the degree of correlation between changes in price for the underlying security and changes in the price of the option. Put another way, Delta indicates the amount of price change in a derivative by comparing changes between asset and derivative prices. Delta is between 0 and 1 for calls and 0 and -1 for puts. A trader can add up the delta for his entire portfolio or the options he owns on the specific underlying security and comes away with one overall delta.
The quantity of each security that the investor would need to buy (or sell short) to achieve the desired hedging effect would be determined using the delta number of each position involved. The closer the total delta gets to zero, the more delta neutral or delta hedged the investor is.
To further understand delta hedging, let’s look at an example. A trader hopes to remain delta neutral in their stock investment for Mega Corp, where they own a put option (which equates to 100 shares of stock). The stock price declines over time, but the put option means the trader is profitable. Then the stock goes up in price, eating into the trader’s gains.
The trader analyzes the market and believes that the stock price is destined to fall again, so he moves to take a delta hedged position to preserve returns. Mega Corp stock has a -.5 delta, so the trader purchases 50 shares of Mega Corp stock at $10 per share for a total of $5,000. The trader can then remove the hedge when advantageous relative to their put option position.
While Delta helps options investors calculate risk and potential return for an investment by quickly telling them how much the price of their option will change per share relative to the price change in the underlying security, there are some downsides. Delta hedging requires constant attention from traders, who must be mindful of market changes and adjust accordingly as prices shift. Done thoughtfully, however, and traders can mitigate risk and protect short-term profits.
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