Shielding Profits in Uncertain Times: Delta Hedging Techniques

Delta measures how much an option’s price will change in response to a one-point movement in the underlying asset’s price. The article explains its significance in the investment world 

The year 2023 has emerged as a remarkable year in the world of contract trading, already breaking records in an unprecedented fashion. The surge in futures and options contracts has been nothing short of extraordinary, boasting a 130 per cent year-on-year growth for 2022-2023, following a noteworthy 125.2 per cent growth in the previous year.

This astonishing increase in trading activity, with a compound annual growth rate (CAGR) of over 70 per cent in the past five years, raises questions about the expanding presence of retail traders, their sometimes-vague trading practices, and the potential risks they take by neglecting essential concepts like delta hedging. [EasyDNNnews:PaidContentStart]

Understanding the Basics 

Delta: The Sensitivity of Option Price to Underlying Asset Movements 

Imagine you have a magical ball that you can bounce. When you bounce the ball, it goes up, and when you stop bouncing it, it comes back down. The speed at which the ball goes up and down is like the delta. If it goes up fast, the delta is big. If it goes up and down slowly, the delta is small. Delta measures how much an option’s price will change in response to a one-point movement in the underlying asset’s price. It ranges from -1 to 1, with call options having positive delta (0 to 1) and put options having negative delta (-1 to 0). 

In bullish positions, your delta is positive, indicating an optimistic outlook. Conversely, in bearish positions, your delta is negative, reflecting a pessimistic stance. When you are dealing with the stock itself (not options), the delta is indeed always 1 for a long (buy) position and -1 for a short (sell) position. Here’s a simple rule to understand delta in options trading:

◼ When an option is ‘out of the money’ (OTM), the delta is closer to 0.

◼ When an option is ‘at the money’ (ATM), the delta is closer to 0.5.

◼ When an option is ‘in the money’ (ITM), the delta is closer to 1 for a call option (it’s like a plus sign), and for a put option, it’s closer to -1 (it’s like a minus sign). 

Example: Call Option

Interest rate is assumed to be 5 per cent, dividend yield is 1 per cent and volatility is 20 per cent. 

When the price of the underlying asset goes up by one unit, the value of a call option will increase by an amount equal to its delta. Additionally, when an option is out of the money (OTM), you can observe how the delta for a call option is closer to 0. 

When the price of the underlying asset increases by one unit, the value of the call option goes up to 0.081, which is the sum of its delta (0.04) and its previous option price (0.041). The same principle applies to put options, but the signs are reversed. When the price goes up by one unit, the value of a put option decreases by an amount equal to its delta. 

Delta Hedging: The Balancing Act of Risk Management 

Imagine you are juggling balls, and each ball represents an investment. Delta is your guide to maintaining balance. When your investments move, delta helps you adjust by buying or selling assets to keep everything in harmony. It’s a risk management strategy, like a financial tightrope walker ensuring you don’t fall too far from your financial goals. By constantly fine-tuning your investments with delta, you are on your way to mastering the art of risk management and keeping your financial performance in equilibrium. 

Delta Hedging Strategy: Long Stock and Short Call 

Suppose you have taken a long position in a stock with 1,500 shares but are concerned about the market heading south. Right now, your total delta exposure is +1,500, which means you have a bullish position. To neutralise your delta and hedge against potential losses, you can sell call options. Let’s assume the delta for these call options is 0.45. Since you want to shift your position to a bearish one, you will have a delta of -0.45 for each call option you sell. 

To completely hedge your delta, you would need to sell approximately 3,333 call options (1,500 | 0.45). This way, you will balance your portfolio’s sensitivity to market movements. 

Delta Hedging Strategy: Long Put and Long Stock 

Let’s say you own a put option for 1,000 shares of a stock, and the delta of this put option is -0.70 (negative because it’s a put option). To delta hedge this position, you would need to buy 700 shares of the underlying stock. This way, if the stock price falls, the loss in your put option’s value will be offset by the gain in the stock, effectively reducing your overall risk. 

Pros of Delta Hedging

1. Risk Reduction: It helps mitigate the impact of price movements on your portfolio. 2. Stability: Provides stability in volatile markets by offsetting directional exposure. 3. Disciplined Approach: Offers a systematic and disciplined way to manage positions. 

Cons of Delta Hedging:

1. Transaction Costs: Frequent adjustments can lead to higher transaction costs.
2. Imperfect Hedges: Perfect hedges are challenging to achieve due to market dynamics.
3. Expertise Required: Effective implementation demands a deep understanding of options and market conditions. 

In conclusion, delta hedging is a technique that can help manage risk in options trading by continuously adjusting hedge positions to maintain delta and gamma neutrality. While it offers benefits in terms of risk reduction, it requires careful execution and ongoing monitoring. It’s a powerful tool in the hands of seasoned traders who are willing to put in the effort to master its intricacies and complexities. 

Disclaimer: The examples taken in the article are only for illustration purpose and most of the values are assumed to simplify the concept. Practically, figures may differ from what is mentioned in the story.

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