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What is Delta Hedging

03 Oct 2023

Introduction

If you're an options trader, you may be familiar with the term "delta hedging." However, what precisely is delta hedging, and how does it operate? This article elucidates the concept of delta hedging, its advantages, and potential drawbacks, and provides practical illustrations of its application.

What is delta?

Delta indicates how much an option's price reacts to the underlying asset's value shifts. For instance, when you purchase a call option for Reliance Industries, you gain the right to acquire 100 Reliance shares at a predetermined price (strike price) before a set date (expiration date). The price of the option (called the premium) depends on various factors, such as the current price of Reliance, the strike price, the time to expiration, the volatility of Reliance, and the interest rate.

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Delta is one of these factors that affect the option price. It informs you how much the option price will change for every one rupee change in the price of Reliance. For example, if the delta of your call option is 0.6, it means that if Reliance goes up by one rupee, your option will go up by 60 paise. Conversely, if Reliance goes down by one rupee, your option will go down by 60 paise.

Delta can range from 0 to 1 for call options and from -1 to 0 for put options. A call option with a delta close to 1 means it behaves like shorting the underlying stock. A put option with a delta close to -1 acts like shorting the underlying stock. A call or put option with a delta close to 0 is very insensitive to changes in the underlying stock price.

What is delta hedging?

Delta hedging aims to reduce or eliminate the directional risk associated with an option position. Directional risk means the risk of losing money due to unfavorable movements in the underlying asset price. For example, if you buy a call option on Reliance, you are exposed to directional risk because if Reliance goes down, your option will lose value.

To hedge this risk, you can use this approach. Delta hedging involves taking an opposite position in the underlying asset or another option with an opposite delta. For example, if you buy a call option on Reliance with a delta of 0.6, you can hedge it by selling 60 shares of Reliance or buying a put option on Reliance with a delta of -0.6. Doing so creates a delta-neutral position, meaning your net delta is zero. Any change in Reliance's price will not affect your overall position value.

Delta hedging protects your profits from short-term fluctuations in the underlying asset price without affecting your long-term view of the asset. However, the strategy needs constant adjustment as your option's delta changes, incurring costs and not eliminating all option risks like time decay and volatility changes.

Example of delta hedging

Consider a scenario where you buy one call option on HDFC Bank with a strike price of Rs. 2,000 and an expiration date of one month from now. The current price of HDFC Bank is Rs. 2,100, and the premium of the call option is Rs. 150. The delta of the call option is 0.8.

To hedge this position, you sell 80 shares of HDFC Bank at Rs. 2,100 each. Your net position value is:

(Option value) - (Stock value) = (0.8 x 100 x Rs. 2,100) - (80 x Rs. 2,100) = Rs. 16,800 - Rs. 1,68,000 = -Rs. 1,51,200

HDFC Bank increased by Rs. 100 to Rs. 2,200 after one week. The premium of the call option also goes up by Rs. 80 to Rs. 230, and the delta increases to 0.9.

Your new position value is:

(Option value) - (Stock value) = (0.9 x 100 x Rs. 2,200) - (80 x Rs. 2,200) = Rs. 19,800 - Rs. 1,76,000 = -Rs. 1,56,200

This means that you have lost Rs. 5,000 due to the increase in HDFC Bank price.

However, if you did not hedge your position, your position value would be:

(Option value) - (Premium paid) = (0.9 x 100 x Rs. 2,200) - (Rs. 150 x 100) = Rs. 19,800 - Rs. 15,000 = Rs. 4,800

This means that you would have made a profit of Rs. 4,800 due to the increase in HDFC Bank price.

Conclusion

Delta hedging is a strategy to mitigate directional risk by counterbalancing positions in the underlying asset or an option with an opposing delta. This approach effectively safeguards against short-term price fluctuations without interfering with one's long-term perspectives. Nevertheless, it's essential to bear in mind that delta hedging has limitations, including potential transaction expenses, the need for continual adjustments, and exposure to risks such as time decay and fluctuations in volatility.

 

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