Delta hedging with options
How to delta hedge with options
The simplest delta hedge just involves trading the underlying. Remember that the underlying has a delta of 1 (or 100%). If you are long the underlying (maybe some shares or an ETF or some commodity futures), your delta is simply the amount of the underlying you are long. And the simplest possible delta hedge, would be to sell out some or all of your longs. But you can also delta hedge using options. The biggest advantage of hedging with options is that you can create more interesting hedge results that are tailored to the portfolio you want to create.
So how do we delta hedge with options? Well, let’s go back to basics. Calls have a positive delta and puts have a negative delta. If the underlying product rallies in price, calls become more valuable and puts become less valuable. Now in order to delta hedge with options, we need to trade so that the p&l from our options when the underlying moves, is the opposite to the p&l from our underlying portfolio. That after all is the nature of a hedge! So, if we are long the underlying, an option delta hedge will involve either selling calls or buying puts or a combination of both. If the underlying price falls, our short calls/long puts will make money back for us. You can learn how to execute a delta hedge in this Volcube training video.
Why use options to delta hedge?
Delta hedging with options gives far greater scope as to the range of outcomes that can be created. Let’s say we have a portfolio which is long some shares on a company. Suppose we think the shares are a good investment in the medium term, but we are concerned about the forthcoming earnings call. Maybe there are rumours that the results for the previous quarter were disastrous and the stock might fall dramatically. Suppose we think the following:
This may seem like quite a complex scenario to plan for, but really it is simple. We want to own the shares, but if the earnings are terrible and the stock really tanks, there is a price at which we want to just bail out and cap our losses. If the stock just falls a little, it would be nice to have some protection against this.
Hedging this risk just by trading the underlying is not really possible. You either sell some or all of the shares. That’s not really going to replicate your preferred payoff. Instead, we can use options to create a more tailored hedge strategy. And it does not have to be incredibly complex. For example, we could just buy some out-of-the-money put options. Let’s say we find some puts with a 10% delta that expire in the next few weeks. If we buy some of these puts, we can create the scenario that matches our preference. If the stock rallies, we will make the same profit on the shares, but probably lose some or all of the money we spent on the hedging puts. Okay, that’s the cost of the hedge. If the stock dips just a little, then our puts should increase in value and cover some of the losses on our long shares. And if the stock really falls out of bed, our losses are capped once we hit the put strike. If the stock falls below the put strike, we can simply exercise our puts and therefore sell the underlying at the strike price. This matches our initial preferences pretty well in a way that just trading the underlying would fail to achieve.
Some risks to think about
It is because options are somewhat more complex than the underlying, that we are able to generate more interesting payoff profiles for different scenarios. However, this also brings some extra risks that we should account for when delta hedging with options.
The main risk is due to the fact that the value of options before expiration is affected by several factors and not just the price of the underlying. For example, implied volatility is an important factor in the value of options and changes in implied volatility can affect their values. So, it is possible for the underlying to fall in price and for the value of puts to fall rather than increase. Another factor is time. Time affects option values and as it passes, their value can fall. You can learn a lot more about these factors in the Resources section of www.volcube.com.
It is true however that option values at expiration are all about the price of the underlying. So, if you intend to hold your option delta hedge until the options expire, you can simply use the strike of the options as the pivot point. At expiration, options are either worth nothing if they are out-of-the-money or the difference between their strike and the underlying price if they are in-the-money. From this perspective, delta hedging with options is very simple. It is only in the days and weeks before expiration that things are slightly more complicated.
You can learn a lot more about delta hedging and option trading generally by practising on Volcube, the world’s leading option trading simulator. Why not start your free trial today?