Delta Hedging

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Delta Hedging Definition

Delta hedging is an investment strategy used in call-and-put options. This strategy reduces risks associated with the movement in the price of an underlying asset. Thus, traders use delta hedging to arrive at a price-neutral state by calibrating risks associated with option prices.

Delta hedging is a complicated technique requiring timely rebalance to ensure the risk is hedged. Once an option is bought or sold, traders usually invest in the same stock and ETF to regulate the risks associated with option price fluctuations. Again, the Delta strategy requires attention to detail. Moreover, it is time-consuming, as it requires regular adjustment of positions.

Delta Hedging Definition

Delta Hedging is an investment strategy that is used to hedge risks associated with fluctuations in the price of an underlying asset.
In addition to delta hedging, traders can opt for Delta neutral trading—the use of multiple positions to make delta variations zero.
The Delta strategy is profitable for short-term gains, but there is still a risk of unexpected price movements. As a result, the investor runs the risk of over-hedging or under-hedging.
This strategy can end up becoming expensive—each trade comes with its own fee and transaction charges.

Delta Hedging Strategy Explained

In options trading, Delta hedging minimizes the risk of price fluctuation. The trader occupies a long or short offset position for the same underlying security. So technically, if the directional risk of price movement brings a loss, the offsetting position balances it.

Options trading here refers to a contract between a buyer and a seller. The option holder bets on the future price of an underlying security or index. On the expiration date, the holder has the right to purchase or sell at the strike price but isn’t obligated to do so.

Traders hedge to offset risks associated with options. Delta hedging is an inversely proportional relationship between the movement in delta hedging options and movements in the offsetting position. When the position is perfectly hedged, the price fluctuations match, and the amount of loss on the option is gained on the asset. This way, investors keep their investment at a breakeven point.

Delta hedging strategy and formula apply to both call options and put options. Here, the Delta represents price variation. For call options, the Delta ranges between 0 and 1; for put options, the Delta ranges between -1 and 0.

For example, if a - 0.25 delta value for a put option signifies that the option's price is expected to increase by 0.25. This means a price fall in the underlying asset is expected. The converse is also true.

Let us look at a delta hedging example. A trader with an options contract for company X that benefits from the price falling also purchases the same company's shares to ensure that stock prices rise. This way, the trader secures both positions.

Delta hedging requires buying or selling an option and the underlying asset. To completely hedge a delta risk, the fluctuation in asset price must be matched by a change in the option price. Therefore, to initiate a delta strategy, a trader must first understand what each delta value denotes, how it works, and other factors.

Hedging Explained in Video

Example

Nikkei's rapid ascent to a three-decade high above 30,000 in February 2021 stunned many experts and analysts. However, there were speculations that market hedging against call options was the cause behind it.

Based on the size of outstanding call options and Nikkei’s moves, many experts predicted Japan's benchmark stock index to add another 1,000 to 2,000 points—within weeks.

Further gains from the current levels were sure to ignite concerns of a growing bubble in Japanese stocks—warnings about a sudden correction increased. On February 16, 2021, Nikkei shares increased moderately for a second session—reaching 30,714.52—the highest since August 1990. The prices kept rising and showed no signs of slowing down till June 2021.

In February 2021, 13,000 Nikkei call option contracts were outstanding—each with a strike price of 30,000 and a notional value of 400 billion yen ($3.79 billion). As a result, call options sellers had to hedge their positions because the likelihood of options being exercised after the expiry date was high.

In such a scenario, the delta hedging strategy would buy Nikkei index futures and push Nikkei higher.

Haruhiko Kuroda exclaimed that the stock price rally reflected market optimism over the global economic outlook. Haruhiko Kuroda was the Governor of the Bank of Japan in 2021. The Governor was trying to refute allegations regarding alleged leniency in Japan’s monetary policy, potentially resulting in an asset price bubble.

Pros And Cons

The advantages offered by the Delta strategy are as follows:

First, it balances investments by minimizing the risk of constant price variations.
By using the delta strategy, portfolios can reach a breakeven point and reduce loss.
The strategy protects short-term stock position and long-term holdings.

There is a downside as well.

Delta value is not constant; it requires continuous monitoring—the positions need to be adjusted accordingly.
It is time-consuming and demands concentration.
Implementing a delta hedging strategy is costly—each trade comes with its fee and transaction charges.
To avoid being under or over-hedged, traders depend on stock volatility. However, a degree of uncertainty persists.

Frequently Asked Questions (FAQs)

1. How to delta hedge?

After taking a position on the options associated with the underlying security, the most common strategy is to invest in the same stock and balance the portfolio. In a way, traders secure both positions if price fluctuations deviate from predictions. So, if the option price results in a loss, it is balanced by the variation in asset price.

2. What is delta-neutral hedging?

Delta neutral hedging is a portfolio strategy; traders use multiple positions to balance positive and negative delta values. Thus, the overall Delta of the assets becomes zero.

3. Is delta hedging profitable?

Delta hedging works both ways. It can potentially help traders forecast a substantial variation in the underlying stock. But on the other hand, it is associated with the risk of being over-hedged if the stock follows market predictions (expected price variation). In addition, the cost rises with every trade—in the form of trade costs and transaction fees.