Delta refers to the rate at which the value of an option changes with the price fluctuations of the underlying security and delta hedging is an options trading strategy to reduce the risk associated with delta. The strategy revolves around arriving at a price-neutral state by hedging against upward or downward price movement of the underlying security.
Limiting risks associated with the directional movement of prices of the underlying securities is important in options trading. If you want to know how to hedge against delta, then you are on the right platform. In this article, we are going to explain delta hedging and strategies you can employ to limit or minimize delta-related risks. Let’s begin right away.
Delta hedging definition
Delta hedging is an options trading strategy that involves minimizing risks or hedging risks associated with the price fluctuations of the underlying security. In other words, the strategy is to achieve zero delta effect by balancing positive and negative delta. Thus, calibrating delta-related risks enable traders to achieve a price-neutral state.
Delta hedging explanation
Delta hedging is a kind of risk management strategy in options trading. Traders employ this strategy to minimize the effects of price fluctuations of the underlying security on the value of the option. How does it happen? It happens because traders enter an offset position for the same underlying security. In other words, if the price of the underlying security causes loss, the second offsetting position offsets the loss. So, it is fair to say that delta hedging matches the loss on one option’s position with the gain on another position.
Moreover, you can apply this strategy to both call and put options. Delta value ranges between -1 and 0 for put options. Whereas, the delta value ranges between 1 and 0 for a call option. So, what do traders do to achieve a neutral position? In simplest terms, if traders buy one call option with a 0.25 delta value also hold a put option with a -0.25 value to offset the first portion. As a result of this strategy, price fluctuations of the underlying security don’t impact overall portfolio value.
Delta hedging strategies
Delta hedging strategy is an umbrella term. Actually, there are numerous different strategies to hedge against delta. It wouldn’t be wrong to say that these strategies are based on common sense. For instance, you will lose money when you hold a position with a negative delta and the price of the underlying security increases. Conversely, you will make money when you hold a position with a negative delta and the price of the underlying security decreases. So, what is the solution to offset the loss caused by this position? Yes, you need a strategy that enables you to make money when the price of the underlying security increases. In other words, you can follow strategies with a positive delta. Therefore, hedge with the following strategies for an original position with a negative delta.
- Short put
- Short put spread
- Long call
- Long call spreads
- Long stock
Contrarily, to hedge a position with a positive delta, you need to employ an offsetting strategy with a negative delta. Therefore, you can utilize any of the following strategies to neutralize your position.
- Short call
- Short call spread
- Long put
- Long put spread
- Short stock
Delta hedging is a very good technique to protect your portfolio. All option traders should learn this technique to limit their losses. You can minimize your losses because of a position by initiating another offsetting position. As a result of this move, you will secure your portfolio because the loss caused by one position is offset by the gain by the second position. So, the net effect on your portfolio remains zero.
Furthermore, delta hedging is a low-risk strategy that neither brings gains nor causes losses. Only expert traders who have expertise can gain through this strategy. Moreover, it is also important to rate that delta values are good for analysis only when prices of the underlying securities stay within a small range. These values themselves change dramatically when the prices of the underlying securities change dramatically. So, if you are employing delta hedging, it is of paramount importance to closely watch your portfolio. It is important because you have to adjust your position along the way to keep the strategy intact. Otherwise, you will end up finding your position over-hedged or under-hedged.