What is delta hedging?
By Simon Gleadall, CEO of Volcube.
UPDATE: Check out this delta hedging video
The delta of any derivative instrument tells us the relation between its price and that of the underlying security. In other words, for a change in the underlying price, the delta represents how much of the change will be reflected in the price of the derivative. For example, a call option with a delta of 0.20 or 20% will increase in value by five ticks for every twenty five tick increase in the price of the underlying instrument.
Delta hedging means trading something somewhere such that the portfolio’s overall delta is zero (or neutral). This would be desirable if we did not want any exposure to changes in the price of the underlying security. So if we own a put option, typically we might expect its value to rise and fall with falls and rises (respectively) in the price of the underlying product. To eliminate these fluctuations, we need to delta hedge. Specifically, when owning a put option, to delta hedge we need to buy a quantity of the underyling product. As the underlying product price rises, our put falls in value, therefore owning some of the underyling product is a hedge against this risk. Even more specifically, the delta tells us how much of the underlying product to buy; for a put with a 20% delta, this represents the hedge ratio and suggests that for every put contract we own, we need to buy one fifth of a lot of the underlying. If we own 100 lots of 20% delta puts, we need to buy 20 lots of the underlying to delta hedge the puts.
A couple of things to note. Delta hedging can be done with any instrument that has a delta with respect to the underlying product and not just the underlying product itself. So a call option with a 60% delta could be delta hedged using two other calls with 40% and 20% deltas respectively. Or puts can be delta hedged using call options struck on the same underlying if traded in the right direction. Secondly, because the delta of options can be a function of many other variables, a delta hedge is usually only temporarily accurate. The underlying product always has a delta of 100% with respect to itself (by definition), but the delta of options and other derivatives depend on, amongst other things, the time they have until expiry or the prevailing implied volatility level, as well as the actual price of the underlying.
You can use Volcube to practise delta hedging option portfolios for yourself. You can learn how to execute delta hedges and also see how delta hedges perform under varying market conditions. Plus you can also use the Volcube auto-hedger to show you how to delta hedge, as well as watch the video on delta neutrality in the Volcube Learning environment.
- Volume I – Option Gamma Trading
Option Gamma Trading (Volcube, 2013) – An accessible ebook guide to option gamma trading, from basic definitions to more advanced gamma hedging and gamma trading techniques as practised by professional option traders. Starting from first principles, option gamma is explained in straightforward English before separate sections on gamma hedging, gamma trading and advanced gamma trading […]
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