If the position is perfectly hedged, the price fluctuations will be perfectly matched so that the same total dollar amount of loss on the option will be gained on the asset. In general, hedging is a strategy used to reduce risk. An investor hedges a position in a particular security to minimize the chance of a loss. The nature of a hedge, though, also means the investor will give up potential gains as well. For example, an investor with an options contract for Company ABC that benefits from the stock price falling would purchase shares of that company just in case the stock price rose.
How Delta Hedging Works
A delta hedge requires the purchase or sale of both an option and the underlying asset. The purpose is to reduce the risk of a price change in the option. To completely hedge the delta risk, the fluctuation in the asset price needs to perfectly match the change in the option price. To initiate a delta hedge you need to first understand what delta is, how it works, and know the delta value for the option you hold. Delta is a measure of how much an options price will change in relation to a change in the price of the underlying asset. For example, assume a call option has a delta of 0.5. That means the price of the call option will increase by 50 cents for every $1 increase in the price of the underlying stock that the call option is written on. Now suppose you have purchased a call option on that stock for $5 and the price of the stock is $60. If the stock’s price rises to $65, then the options price will rise to $7.50.
Creating the Delta Hedge
An investor can hedge delta risk in the previous example by buying the call option, then short-selling the underlying stock. The amount of the underlying stock that must be sold to exactly offset the delta risk is based on the delta. As in our example, if the delta is 0.5, then the investor needs to sell half of the number of securities that are covered by the call option contract. Since a typical option contract covers 100 shares of the underlying security, the investor would need to short 50 shares of the underlying stock to have a delta-neutral position.
Pros and Cons of Delta Hedging
Pros Explained
Protects against small price fluctuations: Hedging with delta makes your portfolio less sensitive to small price changes in the securities you’ve invested in.
Cons Explained
Delta is not constant: Because delta can change over time, delta hedging requires you regularly balance your portfolio to maintain the desired hedge.Could be expensive: The number of transactions you need to make to keep your portfolio balanced can result in numerous transaction fees.
Delta hedging can be used to protect an investor from small fluctuations in price. However, delta values change as the price of stocks and options change. An investor that is employing a delta-hedging strategy will have to regularly rebalance the portfolio to maintain a delta-neutral position. This could generate significant costs.
