Hedging is the strategy to minimize or offsetting the risk of losing money due to market volatility in commodities, currencies, or securities. Hedging is like insurance where we transfer risk. This strategy aims to restrict the losses that may arise due to fluctuations in the prices of investments and lock the profits. Basically, it works on the offsetting principle that is it takes an opposite and equal position in two different markets.
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What is Delta Hedging?
Trading involves several strategies and out of them, one is delta hedging. So what is delta hedging? It is a strategy in options that hedges or lowers the risk linked with an asset’s price movement. In options, the delta hedging strategy is used to minimize risk by establishing short and long positions for the underlying securities.
What is Delta?
In options, the delta is a measure of how sensitive the price of a particular option is to be changed in the underlying asset’s market price. The option’s price applied to its intrinsic value, i.e. what the option would have cost if it had been exercised at that point in time.
Features of Delta Hedging:
Delta is a ratio between the change in the price of an options (C for the call, P for the put) contract, to the change in the price of the underlying asset(s). A call option’s delta ranges from 0 to 1, while a put option’s delta ranges from -1 to 0.
Delta’s behavior is determined by whether it is:
- In-the-money or currently profitable.
- At-the-money at the same price as the strike.
- Out-of-the-money not currently profitable.
An options position could be hedged with options showing a delta that is opposite to that of the current options holding to maintain a delta neutral position. A delta neutral position is one in which the overall delta is zero, which minimizes the options’ price to the underlying asset.
For example, A Call option with Delta=0.5 would change by 0.5 units for every 1 unit change in the price of the underlying asset. Call options have a positive delta value, while Put options have a negative delta value. DeltaNeutral refers to a strategy where the sum total of Delta for your positions is zero. Such a strategy would not get affected by any positive or negative movement in the underlying prices. Delta neutral strategies can be created by Options alone or any combination of Futures and Options.
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If the option of TESLA shares yields a delta of 0.8, it implies that as the underlying stock’s market price rises by $1 per share, the option will rise by $0.8 per $1 rise in the stock’s market value.
For call options, the delta ranges between 0 and 1, while on put options, it ranges between -1 and 0. For example, for put options, a delta of -0.75 indicates that the option’s price is estimated to rise by 0.75 percent if the underlying asset falls by one dollar. Likewise, the reverse is true.
If the underlying asset rises by one dollar, the put option could fall by 0.75. On the other hand, if a call option has a delta of 0.6, it means the call value will rise by 60% if the underlying stock increases by one dollar.
Thus, in-the-money, at-the-money, and out-of-the-money position of an option are associated with its delta. Based on the ranges specified above, if the delta of a put option is -0.5, it indicates that the option is at-the-money (the market price is equal to the strike price). A 0.5 delta is obtained when the strike price of a call option equals the stock’s current market price.
Drawbacks of Delta Hedging:
- Countless transactions might be needed to constantly adjust the delta hedge which will increase the cost.
- In delta hedging, a lot of time and monitoring is required because there is a lot of buys and sell required based on the movement of stocks.
- Depending on the volatility of the equity, the investor needs to buy and sell securities to avoid being under- or over-hedged.
- Delta hedging is very expensive.
- Delta hedging strategy also helps traders to protect their profits arising from a stock/option.
- It’s true that options trading is risky and a trader can lose all his money if he is not managing his options positions carefully. Traders can use delta hedging to see their portfolio from a distinct perspective and evaluate their risk.
- Using delta hedging and other various tools can help the trader manage his risk effectively during highly volatile markets.
Author- Moksha Gala
About the Author: Currently, a graduate in the field of accountancy and finance. Commerce has been a part of my life now. Exploring the available choices, finance was always distinct among them. Credits, investments, and markets were always a part of my interest. So decided to embrace finance as a career for life.