Delta hedging is a risk management strategy commonly used in the financial markets, especially in options trading. The goal of delta hedging is to offset or reduce the risk associated with price movements in the underlying asset. The term “delta” refers to the sensitivity of the option price to changes in the price of the underlying asset.
In options trading, the delta of an option measures the rate of change of the option’s price concerning changes in the price of the underlying asset. Delta is expressed as a number between -1 and 1. The absolute value of delta represents the probability of the option expiring in the money. Positive delta values indicate that the option price is expected to increase with an increase in the underlying asset’s price, while negative delta values suggest the opposite.
The basic idea behind delta hedging is to take offsetting positions in the underlying asset or its derivatives to neutralize the overall delta exposure. This strategy is particularly relevant for market participants who want to hedge the price risk associated with their options positions.
Here’s how delta hedging works:
1. **Long Option Position:**
– If an investor holds a long (buy) position in options, they are exposed to delta risk. The delta of a long call option is positive, indicating that the option price is expected to rise with an increase in the underlying asset’s price. To hedge this risk, the investor takes a short (sell) position in the underlying asset or its derivatives.
2. **Short Option Position:**
– Conversely, if an investor holds a short (sell) position in options, they are exposed to delta risk as well. The delta of a short call option is negative, indicating that the option price is expected to decrease with an increase in the underlying asset’s price. To hedge this risk, the investor takes a long (buy) position in the underlying asset or its derivatives.
3. **Continuous Adjustment:**
– As the price of the underlying asset changes, the delta of the options position also changes. To maintain a delta-neutral position, the investor continuously adjusts their positions in the underlying asset or its derivatives. This involves buying or selling the underlying asset as needed to offset changes in the options’ delta.
4. **Dynamic Hedging:**
– Delta hedging is a dynamic process that requires ongoing monitoring and adjustments. Traders and market participants actively manage their positions to ensure that the overall delta exposure remains neutral or at a desired level.
Delta hedging provides a way for market participants to manage the directional risk associated with options positions. By maintaining a delta-neutral position, investors aim to isolate their portfolios from movements in the underlying asset’s price, focusing on other risk factors such as volatility and time decay. While delta hedging can help manage certain risks, it does not eliminate all risks, and market conditions can impact the effectiveness of the strategy.