If you have known an options trader, chances are that you have come across a phrase called “delta hedging”. Or if you have been reading our blogs recently, we have explained how you can earn money using delta neutral strategies (https://www.plindia.com/blog/straddles-simple-profits-simplified/ ) on our mobile app (https://www.plindia.com/PLMobileApp/ )
This number will determine profitability of any and all portfolios you hold in capital markets and while you may find the following slightly tricky to understand, we suggest you do try!
First, What is Delta!
Delta is a Option Greek . In mathematics, as in options, the word Delta refers to change the change in price of an options position/ portfolio of options versus each Re 1 change in the underlying’s value. The value of Delta indicates the % change in Option price to % change in Stock Price. Example, a delta of +0.4 for an option indicates that the option gains value of 0.4 when the stock gains 1 tick and if it’s a negative Delta -0.4, it means the option will lose 0.4 when the stock gains 1 tick. Typically, At the Money options will have a 0.5 delta and Deep In The Money Puts / Calls will have -1/+1 Delta. All others will be in between -1 and 1.
The Delta applies to your stocks as well – when you hold a share, you are effectively sitting on a Delta of 1 as your P&L changes by Re 1 everytime the share price changes by Re 1. And so on for any and all other positions you can build in capital markets and all kinds of strategies! You are never away from it!
The Deltas for Options are available in our Mobile App in the Analytics section (click the relevant Options contract and you will get an estimate of all the Greeks!).
What’s a Delta Hedge
Delta neutral hedging is a way of desensitising your position against movements in the underlying.
A delta hedge is a simple hedge widely used by derivative dealers , and less by retail investors, to reduce or eliminate a portfolio’s exposure to an underlying. When one is delta hedging an option, we want to make the position “delta neutral” – meaning that we would no longer care what happens to our net position for small movements in the underlying. A delta neutral position is one in which the overall delta is zero, which minimizes the options’ price movements in relation to the underlying asset. For example, assume an investor holds one call option with a delta of 0.50, which indicates the option is at-the-money, and wishes to maintain a delta neutral position. The investor could purchase an at-the-money put option with a delta of -0.50 to offset the positive delta, which would make the position have a delta of zero.
Lets take an example- Suppose you have bought TCS 2700 put option for the month of August. The lot size for TCS is 125 and the delta is -0.48, which means we lose Rs 0.48 for TCS put option that we bought when the underlying (TCS) goes up by just 1 rupee. Therefore , if we wanted to eliminate this delta for some reason and don’t want this movement at all , we would look for an instrument that eliminates this delta completely – like for example, buying shares in this case.
The next question therefore is “how many shares”. This is where the delta gives an answer – in the form of something called the “Hedge Ratio”. Since our position is “Long put” with a size of 125 shares, we need a negative delta position of -60 (calculated as 125*-.48). Meaning, to offset the loss from the put option when prices go up, we need 60 shares of TCS – this will ensure an almost zero profit / loss situation as it has become delta neutral!
You could have done the opposite as well – For example, a long call position may be delta hedged by shorting the underlying stock.
But why engage in Delta Hedging!
You may have exposure to a particular stock. You would normally fear it going down. You thus decide to buy some put options (In simple terms put options give you a profit when the underlying loses value and give you a loss when underlying gains) in order to hedge your position. In layman terms if means Protecting Your Portfolio from Risks
While retail investors don’t do this a lot, institutional and prop books engage in continuous delta hedging to ensure that their exposures to market movements / directional moves are minimal. Such investors often have a portfolio consisting of various options and as the price of the underlying changes, the price of these options change. These changes in the options’ price can change the overall value of the portfolio in a non linear fashion. Therefore, to protect the value of portfolio with the change in the price of the options, Delta hedging is done which is nothing but making the overall Delta of the portfolio zero. However, note that it is method of offsetting the losses (occurred due to change in Delta) with the gains. Therefore, Delta Hedging does not lead to any profits unless and until combined with a strategy. Typically for such payers, Delta Hedging offers insurance against price movements in order to profit from strategies that play on the other aspects of options (Greeks) such as theta and vega. For example, the strategy could be to earn from time lapse or decrease/increase in volatility and you don’t want prices to play a role.
The Key Con!
The estimate of Delta Hedge is accurate only within small ranges and as prices move sharply, the delta itself changes dramatically, Therefore, one of the primary drawbacks of delta hedging is the necessity of constantly watching and adjusting positions involved. Depending on the movement of the stock, the trader has to frequently buy and sell securities in order to avoid being under or overhedged. This technique is called dynamic hedging.
A very dynamic person may end up making his broker and the Government very rich unless he or she happens to be an entity which doesn’t get charged quite a few things that a typical client does!
While you may , (if you are reading this line Congratulations! For your patience) not wish to be engaged in Delta Hedging except as a casual buyer or seller of options contracts, you may definitely want to now believe you know the danger that the Deltas present!