Delta hedging is a trading strategy that reduces the directional risk associated with the price movements of an underlying asset. The hedge is achieved through the use of options. Ultimately, the objective is to reach a delta neutral state, offsetting the risk on the portfolio or option.
How Delta Hedging Works
Generally, the most common method of delta hedging is when an investor purchases or sells options and offsets the risk by respectively buying or selling an equal amount of stock or ETFs. Other strategies would include trading volatility through delta neutral trading.
Considering that delta hedging is meant to reduce the volatility of the option’s price relative to the movement in the underlying asset’s price, it constantly requires rebalancing to ensure the risk is hedged. Delta hedging is known to be a complex strategy used by institutional investors or large investment companies.
Delta is defined as the change in the value of an option relative to the change in movement in the market price of an underlying asset. For example, if the option of TSLA 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 implies that the price of the option is expected to increase by 0.75, assuming the underlying asset falls by a dollar. The vice-versa is the same as well.
If the underlying asset increases by a dollar, the put option is expected to decrease 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.
Delta is correlated with whether the option is in-the-money, at-the-money, or out-of-the-money. 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). For call options, however, a 0.5 delta is when the strike equals the market price of the stock.
In-the-money is a term that indicates that the option contract yields value, as its strike price is in a favorable position based on the market price of the underlying asset.
A call option is in-the-money when the market price is above the exercise price. In such a scenario, it means the option holder has the chance to buy the security below the market price and at the strike price.
For example, if an investor entered into a call option contract to buy a Tesla stock for $15 in the future and that by the time the contract expires, the market price of the equity is $17, it means the call is in-the-money and that the investor would save $2 per stock agreed upon.
A put option is in-the-money when the market price is below the exercise price. As put options provide holders the right to sell the security at the strike price, they have the opportunity to make money by selling their stock at a value higher than what is offered in the market.
At-the-money is a term where the option’s strike price is equal to the market price of the underlying asset. Both call and put options can be at-the-money. For example, if the call and put option price on APPL is $100, yet the market price is also of the same value, it would indicate that the contracts are at-the-money. Besides time value, at-the-money contracts yield zero intrinsic value.
Out-of-the-money is an expression that describes an option contract that yields zero intrinsic value while containing some extrinsic value. An option that is out-of-the-company occurs in the following circumstances:
When the strike price is higher than the market price of the underlying asset. It means that the investor has the opportunity to purchase the asset at a price higher than what the market offers, which is unprofitable.
When the strike price is lower than the market price of the underlying asset. It means that the investor has the right to sell the asset at a price lower than what the market is offering, which is unprofitable.
Pros of Delta Hedging
Delta hedging provides the following benefits:
It allows traders to hedge the risk of constant price fluctuations in a portfolio.
It protects profits from an option or stock position in the short term while protecting long-term holdings.
Cons of Delta Hedging
Delta hedging provides the following disadvantages:
Traders must continuously monitor and adjust the positions they enter. Depending on the volatility of the equity, the investor would need to respectively buy and sell securities to avoid being under- or over-hedged.
Considering that there are transaction fees for each trade conducted, delta hedging can incur large expenses.
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