I’m sure you’ve all heard of the saying “hedge your bets.” Chances are, you already do it and don’t even realize it. For example, buying life insurance to support your family for your death is hedging. With all the recent news on the pending demise of the stock market, you’re probably wondering how you can hedge your bets. For those of you wondering what delta hedging is and is it for you, you’ve come to the right place.
A Real-Life Example of Hedging
Hedging in its literal meaning means ‘to protect.’ A real-life example of hedging is buying car insurance. Of course, you could choose to go without, but that means you have unlimited liability.
Whereas with insurance, your liability’s capped. And the price you pay for this peace of mind is the premium you pay. Hedges in real life are planted to offer protection to people.
If you want privacy what do you do? You plant a hedge. Especially if you don’t want to shell out money for a privacy fence. And hedges can be an attractive way to protect your house.
However, you have to maintain a hedge. You have to water it and trim it to keep it from dying.
Hedging in finance is no different.
Hedging In Finance
In the finance world, we hedge to protect our portfolio from risk. We do this by investing in different assets that are inversely correlated. In other words, when one goes up, the other goes down.
As far as the stock market is concerned, investors hedge when they are unsure what the market will do. A well-executed hedge reduces your risk when share prices suddenly fluctuate in your primary position.
5 Second Takeaway
- Anything that lessens the impact of a loss or reduces liability to something we call hedging.
- Delta hedging reduces the risk of price movements in the underlying asset by offsetting long and short positions.
- The Delta represents how much of the change in the underlying will be reflected in the derivative price.
- A delta hedge will only protect you against small movements in price of the underlying.
- You won’t make any profits from Delta Hedging unless combined with a strategy. Check out Bullish Bear’s courses on options to learn more here.
A Quick Refresher On Options
What Does Delta Mean? The word Delta refers to change. When referring to derivatives, Delta tells us the relation between its price and underlying security. The value of Delta indicates the % change in the Option price to % change in Stock Price.
For example, a call option with a delta of 0.20 or 20% will increase in value by five ticks for every twenty-five tick increase in the underlying instrument’s price. Alternatively, a delta of 0.4 means that the option gains a value of 0.4 when the stock gains one tick.
What Is Delta Hedging?
Designing your portfolio so that the gains exactly offset losses is called Delta Hedging. We do this if we don’t want to be exposed to the underlying securities price changes.
Derivatives dealers widely use a delta hedge to reduce or eliminate a portfolio’s exposure to an underlying’s change in price. What about a delta hedge when you own a put option?
If we own a put option, we should expect its value to rise and fall as the price of the underlying rises and falls. To eliminate these fluctuations, we need to delta hedge.
Specifically, when owning a put option, to delta hedge, we need to buy a quantity of the underlying product.
As the underlying product price rises, our put falls in value, therefore owning some of the underlying product is a hedge against this risk.
The Delta Tells Us How Much To Buy
Delta is useful; it tells us how much of the underlying product to buy. To illustrate, let’s use a put with a 20% delta. This ratio means that for every put contract we own, we need to purchase one-fifth of a lot of the underlying. So if we own 100 lots of 20% delta puts, we need to buy 20 lots of the underlying to delta hedge the puts.
Are you confused yet? Take our options courses to help unravel the maze. When we are 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 underlying.
Don’t be fooled by a zero delta portfolio either. A portfolio that has zero Delta is said to be Delta neutral. But don’t be Delta fooled and think you have no risk. Let me explain why: A portfolio can have multiple underliers, which means numerous exposures. So even though it may be Delta neutral for one underlier, the others may be Delta positive or Delta negative.
The Solution To Moving Underliers: Dynamic Hedging
One thing we know for sure is that price moves. And this poses a constant problem when Delta hedging an options position. A constantly moving underlying equals a constantly moving delta, throwing off your delta hedge. So what does one do to solve this dilemma? Otherwise known as dynamic hedging, you regularly adjust the delta hedge as the underlier moves.
An Example of Delta Hedging
An example of a delta hedge is when you buy a put, which gives you negative Delta and positive gamma, and then buys enough of the underlying to zero out your total Delta.
Let’s say you have exposure to a particular stock as you anticipate negative earnings. Because of this, you decide to buy some put options to hedge your position. Put options profit when the underlying loses value. So if the worst-case scenario comes true and your stock falls in price, your well-positioned put option would profit.
Why You Should Consider Trading Options and Delta Hedging
Without a doubt, options are one of the most versatile trading instruments out there. In my opinion, the main advantage of options is that your risk is limited to the cost you paid for it. Because you don’t own the underlying security, you don’t have to worry about losing your shirt if the stock price goes against you.
So, at the end of the day, I encourage you to learn how to run option spreads; many trade them for a living. They are a great way to minimize your risk and live to trade another day, and we’ll show you how!