What is Delta Hedging?
Option trading strategies involve a series of permutations and combinations to maximize profits and minimize risk. Delta hedging aims to offset the risk to either a single Option or the entire portfolio.
Delta Hedging is an Options strategy designed to reduce or limit the directional risk involved with price movements of the underlying asset. The ultimate goal is to achieve a delta-neutral state. Primary types of delta hedging involve purchasing or selling Options and simultaneously purchasing or selling an equivalent number of shares or ETF shares.
Delta refers to the ratio of change in the value of the Options contract relative to the change in the price of the underlying asset. The value of an Option is a function of the premium paid or received to purchase or sell the Option. The delta for a call Option ranges between 0 and 1 whereas the delta for a put Option ranges between 0 and -1.
For example, the delta of a call Option is 0.45 indicates that if the price of the underlying increases by Re. 1 then the value of the Call Option will increase by Rs. 0.45. Similarly, the delta for a put Option is - 0.70 which implies that if the price of the underlying increases by Re. 1 then the value of the Put Option will decrease by Rs. 0.70.
The delta of an Option has a direct correlation with whether the Option is in-the-money, at-the-money, or out-of-the-money. An in-the-money option implies that the strike price is favorable as compared to the market price of the underlying asset. A Call Option is in-the-money when the market price of the underlying is higher than the strike price of the call. On the other hand, a Put Option is in-the-money when the market price of the underlying asset is lower than the strike price of the call. The delta of an in-the-money Option will be greater than 0.50.
An option is at the money when the strike price of the Option is the same as the market price of the underlying. Delta of the at-the-money Option is 0.50. An out-of-the-money Option contains an extrinsic value. If the strike price of a Call Option is higher than the market price of the underlying then the Option is said to be out-of-the-money. Whereas a Put Option is out-of-the-money when the strike price of the Option is lower than the market price of the underlying. The delta of an out-of-the-money Option is lower than 0.50.
A trade may be hedged by entering into a contract with a delta opposite to the current holdings. A delta-neutral strategy refers to a position where the overall delta is zero. Thus, a delta-neutral strategy minimizes the risk associated with price movements of the underlying asset. For example, to hedge a Call Option, a trade may short sell the underlying stock or sell an Option to minimize the risk.
It is pertinent to note that delta constantly varies based on the price movement of the underlying. Hence, delta is dynamic and, in all probabilities, requires rebalancing.
Pros and Cons of Delta Hedging
The primary benefit of delta hedging is mitigating the risk involved with adverse price fluctuations. Even more so, the case if a trader anticipates a strong price movement in the underlying stock but runs the risk of being over hedged if the stock does not meet the trader’s expectation.
On the contrary, delta hedging is subject to constant monitoring and rebalancing. A position may be rebalanced multiple times in line with price movements. A trader may be required to execute various buy and sell transactions to hedge the risk involved. As a result, the cost of hedging may increase.
Transaction charges are levied as adjustments are made to the position. Further, hedging with Options also involves the time value of money which reduces over time. The time value of money is zero at the expiry of the Option contract. Lastly, sudden and expected price changes may result in over hedging. Traders may also over hedge if the delta is offset by too much.
Similar to the two sides of a coin, delta hedging has its benefits and disadvantages. However, delta hedging requires cautious monitoring and is best suited for experienced financial institutions.
How does Delta Hedging Work?
Having understood the definition of delta hedging, let’s consider an example to analyze the framework of delta hedging. Suppose a trader purchases 10 called Options of XYZ Ltd. The delta of the Option is 0.40 whereas the lot size is 100 shares. Thus, if the price of XYZ Ltd. increases by Rs. 10 then the value of the Option will increase by Rs. 10 * 0.40 which is Rs. 4.
To hedge the position, the trader will have to short sell shares of XYZ Ltd. The number of shares may be calculated as a function of 10 call Options, the delta of 0.40, and the lot size of 100 shares. Thus, the trader will short sell 400 shares to maintain a delta-neutral holding.
Similarly, a trader has 20 put Options of ABC Ltd with a delta of - 0.75 and a lot size of 100. To hedge the position, the trader must purchase 1500 (20 * 0.75* 100) shares of ABC Ltd. Delta of Options is constantly changing and hence the number of shares bought or sold in the above examples is to be monitored and rebalanced frequently.
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Frequently Asked Questions
To calculate the delta hedging quantity, the absolute value of delta is multiplied by the number of Option contracts. The product is further multiplied by the number of shares in a lot. Referring to the above examples, the delta hedge quantity of 400 shares and 1500 shares of XYZ Ltd and ABC Ltd respectively has been calculated similarly.
Delta Hedging is a defensive trading strategy. The primary purpose of the strategy is to hedge the risk associated with an open position and not to profit from the trade. Thus, delta hedging is undertaken to limit the loss rather than earn profit from the trade.
Dynamic delta hedging mainly involves hedging a non-linear position with linear instruments. Linear instruments include spot, forward and futures contracts. The deltas of linear and non-linear positions offset and yield an overall zero delta position.