Delta Hedging: Meaning, Example, Pros & Cons
Trading in derivatives can be a complex phenomenon due to the volatility of prices of the underlying assets. Therefore, traders use several tools and strategies to reduce the chances of their losses and maximise their gains.
One such strategy is delta hedging which is applicable in options trading. In this, individuals or market participants undertake short and long positions in an options trade to minimise the risk associated with directional changes in the price of underlying assets.
Let’s understand how delta hedging works, as well as its pros and cons.
What Is Delta?
We have briefly discussed delta hedging, which is a trading strategy. Now, let’s see what delta is about. Delta is an indicator that measures the rate of change in the premium of a derivatives contract with regard to movement in the underlying asset’s price.
Delta can be a positive or negative value depending on trading positions. The call options will come with a positive delta, whereas put options have negative delta values. In the case of the former, delta value ranges from 0 to 1, and for the latter, delta value fluctuates from -1 to 0.
How Does Delta Hedging Work?
As the name suggests, delta hedging is all about hedging or lowering market risks associated with changes occurring in the price of underlying assets. The primary objective of this strategy is to achieve a delta neutral state. The most popular way of delta hedging is buying or selling an options contract and, at the same time, purchasing or selling an equivalent number of stocks.
Other ways include trading volatility via delta neutral trading. As this strategy takes care of the risks associated with changes in options price when there is a movement in the price of underlying security, it involves constant manoeuvring and rebalancing as per market situations.
You can hedge a trade by entering a contract with the delta variable, which is completely opposite to the present portfolio. Delta neutral phase means the overall value of delta will be zero. These strategies are quite popular with large investment houses and wealthy traders.
Example of Delta Hedging
Let’s see an example of delta hedging, to better understand this concept. Suppose a trader has bought 20 call options of a company ABC Limited. The delta value of this options contract is 0.50. Moreover, the lot size of these options is 200.
Therefore, we see that if price of shares of ABC Limited increases by ₹10, in that case, the value of their options will increase by 10* 0.50 = ₹5. Now, for hedging this trade, individuals will have to short sell shares of ABC Limited. The number of shares for short sell can be calculated as a function of delta value, lot size, and 20 call options.
Hence, it will come out to be 2000 shares. This means that the concerned trader must sell 2000 shares of ABC Limited in the open market to undertake a delta neutral position.
Now, let’s say that the same trader has 10 put options with a delta value of -0.50 and the lot size of the options is 100. For hedging purposes, the respective trader will have to purchase a certain number of stocks of the company. After following the same method, we see that an individual must purchase 500 shares to hedge the position.
One important thing about delta hedging is that the value of delta is dynamic and keeps on changing as per market movements. Therefore, it requires constant monitoring and reviewing from the investor’s side.
What Are the Pros of Delta Hedging?
First, we will discuss the advantages of delta hedging, which are as follows:
- Hedging with delta acts as a shield for the investment basket against small price changes in underlying assets. It makes the portfolio less sensitive to minor price fluctuations.
- It eliminates the risk involved with significant price changes. If a trader expects that certain underlying assets will see a significant shift in future, he/she can hedge a delta which will help in minimising the losses.
What Are the Cons of Delta Hedging?
Now, let’s shift our focus to limitations or cons associated with delta hedging:
- As delta keeps on changing as per market situations, you need to frequently adjust or rebalance your portfolio and trading positions. This is a complex and time-consuming process which might not be suitable for small traders.
- As a part of rebalancing the position, you need to undertake several buy and sell transactions multiple times. This adds to the overall transaction costs and reduces eventual profitability.
- Over-hedging can also be a problem for traders. This can happen due to sudden and unexpected changes in an asset’s price.
What Are the Factors to Consider in Delta Hedging?
Here are some factors that one should keep in mind before going for delta hedging:
- Value of delta variable
- Number of call or put options executed
- Gamma variable
Delta hedging is a common method of risk mitigation or management when dealing with derivative trading. It depends on the delta variable, which keeps on changing continuously. This results in traders constantly rebalancing their portfolios, which can get complex and tiring at times. Traders are advised to understand all intricacies related to delta hedging before going ahead with any decision.
Frequently Asked Questions
What are the delta values for various options positions?
In case of in-the-money options, the delta value will always be higher than 0.5. For at-the-money options contracts, the delta value will be 0.5. However, for out-of-money options contracts, the respective delta value will be lower than 0.5.
What is the gamma variable?
It is an upgraded variable in relation to the delta variable. Delta measures the price sensitivity of an options contract when the underlying asset’s price changes. On the other hand, gamma measures the rate at which delta changes whenever there is movement in the underlying asset’s price.
Is delta hedging profitable?
Yes, delta hedging can be profitable, particularly during the short term. In the long run, it may or may not be profitable depending on changes occurring in the asset’s price.
Why is delta lower for in-the-money options having equivalent strike prices but different expiration dates?
Delta is a smaller value in this case because as the expiration timeline increases, the chances of options contracts remaining in-the-money gradually reduce.