For decades, institutional traders have limited the risk exposure of their portfolios by implementing delta hedging strategies. These methodologies are now gaining popularity among retail traders in the stock, currency, and futures markets.
In finance, the term delta refers to the ratio of change between the price of an asset and the price of its derivative products. Delta is commonly used to measure the relationship between securities and their corresponding options contracts. By viewing the instruments in tandem, a trader can apply observed correlations to various risk management strategies, including delta hedging.
To illustrate the concept of delta, assume that Sidney the stock trader has bought 900 shares of Microsoft (MSFT) at $150 per share. Following the purchase, Sidney studies the options chain for MSFT and notices that the delta for a July 1 call with a strike price of $150 is 0.9800. This means that as shares of MSFT gain $1, the premium on the July 1 call moves by $0.98—a positive correlation of 98 percent.
It’s important to remember that options contracts come in two forms: calls and puts. Accordingly, delta values may be either positive (calls) or negative (puts). If Sidney were to review the options chain with respect to a July 1 MSFT put, a value, such as -0.0155, may be listed. Because put options are bearish derivatives, the negative delta indicates that as the price of MSFT increases, the price of the put option decreases.
What Is Delta Hedging?
Delta hedging is an advanced risk management strategy designed to eliminate the downside potential of an open position at market. To execute the strategy, options traders use contracts to offset the negative impact of bullish or bearish moves in asset pricing. The primary goal of such strategies is to achieve a delta neutral state, effectively eliminating exposure to market risk.
Let’s assume that Sidney has had some good luck with MSFT. Prices have spiked to $180 per share, and things are looking up. For tax reasons, liquidating the position is a nonstarter, and Sidney is still bullish on MSFT. However, limiting risk is becoming attractive because the realized gains are substantial.
By using delta hedging, Sidney can protect the 900 share open position by buying put options with a strike price of $180. The delta for July 1 puts with a strike of $180 is listed at -0.9500; Sidney purchases nine contracts (100 shares per contract) to make the MSFT position delta neutral.
Sidney’s example is a basic look at how a trader can use delta hedging to mitigate risk in the equities markets. However, the strategy has countless variations and may also be applied to futures, options, and options on futures. In practice, long positions in the E-mini S&P 500 or WTI crude oil can be protected in a similar fashion. As long as an asset has an options chain, it’s possible to seek a delta neutral state.
Interested in Learning More?
There are few things in finance more advanced than options pricing and portfolio hedging. A variety of obscure factors can drive values up or down, including technicals, fundamentals, and even the passage of time. It’s a good idea to consult an expert in the field before committing real money to the markets.
If you’re interested in learning more about futures, options, and delta hedging, a consultation with a Daniels Trading broker is a great place to begin. Featuring a unique cross-section of experience and industry knowledge, the Daniels team stands ready to help make your journey into the marketplace a successful one.