Options trading is risky, especially for retail investors. According to the Securities and Exchange Board of India (SEBI), approximately 90% of retail traders engaging in options and other derivative contracts end up losing money. By the financial year ending March 2022, retail investors lost $5.4 billion. This creates the need for a robust risk management mechanism that allows investors to engage in such high-risk trading while maintaining profitability.
Among the popular strategies, delta hedging stands out as an effective risk management approach. Let us learn what it is and how you can use it to optimise your trading decisions.
What is delta hedging?
Delta hedging is a risk management strategy. It is commonly used in options trading to reduce or eliminate the risk associated with changes in the price of the underlying asset.
The term "delta" refers to the sensitivity of an option's price to changes in the price of the underlying asset. It determines the anticipated change in the option's price for a Rs. 1 fluctuation in the underlying asset's price.
For example,
| Let’s say the delta of a call option is 0.70 | Let’s say the delta of a put option is -0.40 |
| This indicates that for every increase of Rs. 1 in the price of an underlying asset, the call option's price is anticipated to increase by Rs. 0.70. | This indicates that for every increase of Rs. 1 in the price of an underlying asset, the put option's price is anticipated to rise by Rs. 0.40. |
How does delta hedging work?
When you buy or sell options, you are exposed to changes in the underlying asset's price. In delta hedging, you hedge the delta risk of the options position by taking an offsetting position in the underlying asset.
Let us understand better with a hypothetical delta hedging example.
The scenario
- An options trader purchased a call option for a stock with a strike price of Rs. 1000.
- The delta of this call option is 0.60.
The hedge
- To hedge the delta risk associated with this call option, the trader uses the delta hedging strategy.
- They decide to take an offsetting position in the underlying stock.
- Say the current price of the stock is Rs. 950.
- To hedge, the trader calculated the delta-adjusted position in the stock.
- Since the delta of the call option is 0.6, the trader would need to sell short 0.6 shares of the stock for each call option held by the trader
- The trader calculated this in the following way:
- 0.6 (delta of the call option) * Rs. 950 (current stock price) = Rs. 570
- So, for each call option the trader held, they would sell short Rs. 570 worth of the underlying stock.
The neutralisation effect
Now, there could be two possible situations:
| The stock price increases by Rs. 1 | The stock price decreases by Rs. 1 |
| The value of the trader’s call option would theoretically increase by Rs. 0.60.But they would lose Rs. 0.60 on their short position in the stock.Ultimately, this resulted in a net gain of Rs. 0. | The value of the trader’s call option would theoretically decrease by Rs. 0.60.But they would gain Rs. 0.60 on their short position in the stock.Again, the net gain will be of Rs. 0. |
The outcome
- Using delta hedging, the trader effectively neutralised the delta risk of their call option position.
- They protect themselves from losses due to fluctuations in the stock price.
What is the role of delta in delta hedging?
Delta tells a trader how much an option's price will change when the price of the underlying asset changes. Its range varies for both call and put options. Read the table below:
| For put options | For call options |
| Between -1 and 1 | Between 0 and 1 |
Options traders look at delta to see how much their options might change in value when the price of the underlying asset changes. They use this information to ascertain how risky their investments are. The various levels of delta offer different indications to the traders. Let’s study them:
| Delta values | Call option (price indications) | Put option (price indications) |
| Close to 1 | The option's price moves almost in tandem with the underlying asset's price. | NA |
| Close to 0 | The option's price doesn't change much with changes in the underlying asset's price. | The option's price doesn't change much with changes in the underlying asset's price. |
| Negative delta | The option's price moves inversely to the underlying asset's price (typical of deep out-of-the-money call options) | NA |
| Close to -1 | NA | The option's price moves almost inversely with the underlying asset's price. |
| Close to 0 | NA | The option's price doesn't change much with changes in the underlying asset's price. |
| Positive delta | NA | The option's price moves in tandem with the underlying asset's price (typical of deep out-of-the-money put options). |
Conclusion
Options trading is risky with a majority of retail investors often losing money. This creates the need for employing effective risk management strategies such as delta hedging to minimise the loss potential. Using this technique, traders can neutralise the delta risk of their options position and control their risk levels.
You can also improve your trading skill set by learning top options trading strategies and intraday trading strategies.
