Last Updated on September 22, 2023 by BFSLTeam BFSLTeam
Traders often use a plethora of different strategies depending on the type of security that’s being traded. The use of trading strategies can not only help you achieve profits but also reduce the risk involved with trading and adverse market movements.
If you’re interested in trading in options, irrespective of whether it is stock options or index options, the delta hedging strategy is one of the best trading strategies you should consider using.
Want to know more about delta hedging? Continue reading to find out all about this strategy and how you can use it to mitigate the impact of adverse market movements. But before that, let’s quickly go through the concept of delta.
Also Read: Be Aware of Buy and Hold strategy in the Stock Market
Table of Content
What is Delta?
In the context of options, delta is a metric that represents the rate of change in the options premium based on the price movement of the underlying asset. The higher the delta, the greater the change in the options premium.
For example, let’s say that the call option of a stock of ABC Limited has a delta of 0.50. This would mean that for every ₹1 rupee change in the stock price of ABC Limited, the options premium would move by ₹0.50.
The delta for both call options and put options varies slightly. In the case of call options, the delta moves between 0 and 1, whereas for put options, the delta moves between -1 and 0. Furthermore, the delta of an options contract is not static. It changes over time with the change in the underlying asset’s price. The rate of change of the delta of an options contract is measured by another metric known as gamma.
What is Delta Hedging?
Now that you’re aware of what delta is, let’s look at what the delta hedging strategy is all about.
Delta hedging is an options strategy where traders attempt to reduce the impact of price movements in the underlying asset on the options premium. The primary objective of such a strategy is to reach a ‘delta-neutral’ state, where minor price movements in the underlying asset don’t affect your position.
There are two ways through which traders use the delta hedging strategy. The first option is to hedge an option’s position by either purchasing or selling the underlying stock. The second option is to hedge an options position by entering into an opposing options position.
Alternatively, some experienced traders use a unique delta hedging strategy where they trade volatility to achieve delta neutrality. However, this strategy can be very complex and is more suitable for experienced institutional traders.
Also Read: What is the Wash Sale Rule?
Delta Hedging: An Example
With the meaning of delta hedge out of the way, let’s look at a couple of delta hedging examples – one with options and the other with equity.
Example 1: Delta Hedging with Options
Assume there’s a company XYZ Limited. The stock is currently trading at ₹100. Since you expect the price to go up in the future, you decide to purchase 1 call option contract at a premium of ₹10 per share. The lot size of the options contracts of XYZ Limited is 1,000 shares. The delta of the call options is 0.40, meaning that for every ₹1 change in the stock price, the options price would go up by ₹0.40.
Now, since you wish to achieve a ‘delta-neutral’ position where minor price movements don’t affect your positions, you decide to execute a delta hedging strategy. You do this by purchasing one put option contract with a -0.40 delta.
Since the deltas of both the call option and put option are the same, they cancel each other out, giving you a delta-neutral position.
Example 2: Delta Hedging with the Underlying Asset
Alternatively, some traders prefer using the underlying asset to hedge the options contract delta. In this case, here’s what you would have to do. For the sake of continuity, let’s use the same example as the one mentioned above.
Now, you have 1 call option contract of XYZ Limited with a lot size of 1,000 shares bought by paying a premium of ₹10 per share. The delta of the call option contract is 0.40. To set up a delta hedging position with the underlying stock, all you need to do is short-sell a certain number of the underlying stock. You can use the formula mentioned below to find out the number of shares you would need to short-sell to achieve delta neutrality.
| Number of shares = Number of options contracts x option delta x lot size |
Going by the above-mentioned formula, you would have to short-sell 400 shares (1 x 0.40 x 1,000) of XYZ Limited to neutralise the delta of the call options contract.
The same method would work even if you had a put options contract and wish to delta hedge it. The only difference is that you would be required to purchase 400 shares of XYZ Limited to offset the delta and achieve neutrality.
Conclusion
As you can see, the delta hedging strategy requires you to combine both call and put options. This effectively creates a neutral position, protecting you from price movements on both sides. That said, delta hedging only protects you from minor price movements and provides little to no protection from large, sudden or volatile movements. Furthermore, the strategy needs to be dynamically adjusted according to the market movements for maximum effectiveness. This makes the delta hedge slightly more complicated than most other options trading strategies.
Therefore, if you’re planning to use this strategy as part of your risk management plan, make sure to first back-test it thoroughly. You can use a virtual trading platform to extensively test the strategy before using it. This will ensure that you don’t run into any issues when trading in real time.
