Meaning of Delta Hedging

Delta hedging is one strategy that can be used to trade. Delta hedging is a strategy that lowers or hedges risk associated with asset price movements.

The delta hedging strategy can be used to reduce risk by opening short and long positions on the underlying asset. In this way, there is less risk in a directional sense and more neutrality. Delta neutral situations are where the price of an option is not affected by any changes in the price or assets of the underlying stock.

Delta hedging strategies aim to minimize or reduce risks associated with price movements of an underlying asset.

What's a delta?

You may be wondering what delta is, now that you understand what delta hedging is. Delta is the rate at the which the premium changes based on the direction of the underlying asset's movements. Delta is an indicator of the degree of sensitiveness of an option's price to changes in its underlying asset's price. This is the intrinsic value of an option, which is the price at which it can be purchased. The value of the option, if executed at the current time.

Call options tend to have delta positive, while put options tend have delta negative. Delta refers to the range from 0-1 in call options, while it is 0-1 in put options.

Consider also that an option with an ITM (in-the-money) delta will be greater than 0.5, while an option with an ATM (at-the-money) delta will be less than 0.5. A delta of less than 0.25 will be found for an out-of-money option (OTM). A given option can move from OTM to ATM, then back to ATM, or vice versa, depending on the price change.

How can traders use delta to hedge?

An example of delta hedging may help you understand what delta hedging is and how it is done. Options positions can be hedged using shares of the stock underlying. A stock share will have a delta value of 1, which is because the stock's price increases by Rs 1 for every Rs 1 increase in stock.

Let's say a trader has a call option worth 0.5. The trader can hedge one stock lot with 650 shares by selling 650 shares.

It is important to remember that traders may not use the same scale for measuring delta in options. Traders can use both the 0-1 and 0-100 scales to measure delta in options. The 0.40 delta value for one scale is 40 for the other. Scale 0 to 100

This is another example of delta hedging to help you get a better grasp on this strategy.

Let's say a trader owns 20 call options on ABC. The option delta for these call options is 0.25. You have 20 x 0.25x100 shares, or 500 ABC shares. Delta hedging would require you to sell 500 shares to offset the call options if you wanted to purchase this position.

Similar to the above, if 25 put options on JKL have a delta of 0.75, that means your position is short 1875 shares (25x -0.75x 100). This is where delta hedging comes in to play. You can buy 1875 shares JKL to make up the difference.

Factors to Consider When Hedging Delta

To hedge the delta of a call option, you might have to short-sell underlying stock or sell options to offset the delta risk. Short selling stock is a way to hedge the delta. It would involve shorting stock at a specific price equivalent to the delta. The trader would need to shorten 50 ABC stock shares if one call option on ABC stock has 50% delta.

Because of constant price changes or the time leading up to expiration, delta is always changing. Gamma is then introduced. Gamma is the measure of an option's sensitivity for price changes in its underlying asset. However, delta measures the price at which the option price reacts to changes in that asset. Gamma measures the price at which delta changes are perceived relative to changes in stock price. Gamma, in other words is the rate at the which delta changes for every one-point change in the underlying stock price.

Conclusion

Delta hedging is a strategy that reduces or eliminates the risk of price changes. The delta hedging strategy helps traders protect their profits from stock/option.