An Introduction to Delta Hedging

If you have traded options before, you may have heard the term delta hedging. The most followed analytical variables for options are delta, theta, vega, rho and gamma. Delta is the Greek symbol for change, and in finance, the term means the price sensitivity of the option in regards to the underlying instrument.

Delta hedging is a technique used by professionals who trade options on a daily basis because trading in an options pit requires many transactions; the total delta is the entire exposure of the professional trader.

Delta Value

The meaning of delta neutral is a delta of 0, which means that no matter how the underlying instrument moves, the options will not change in portfolio value.

One better interpretation of the delta is the probability of its being in the money. If it is an at-the-money option, most likely it will have a probability of 50 percent for being in the money. Normally, an at-the-money delta is 0.50.

The way to balance the delta is to buy and sell call and put options, whichever is favorable. The calls have positive deltas, and the puts have negative deltas. Take, for example, the options trader who has an entire portfolio with the delta equal to 2.25. The call option that would make this portfolio delta neutral could be, for instance, the one with a delta of 0.75. What should the options trader do? In this instance, the options trader should write three of these 75 percent delta calls. What about a put option with a 75 percent delta? Well, in this instance, he would buy three of these puts.

Professional traders use the analytical tools to stay up to date as the market moves during trading hours. That means during mid session if the delta were, for example, 0.03, the trader would be essentially delta neutral. If the portfolio delta is 1 or higher, the portfolio is not delta neutral. That means that the professional trader has to make adjustments to the portfolio to bring the delta near zero.

Delta Neutral

When the portfolio is near zero delta, the professional trader does not have to worry about the changes in the market; the portfolio is near delta neutral. With that said, the professional trader can choose a bias to go long or short whenever he believes there is an opportunity for profit. Once the bias is established, the portfolio is exposed to the changes in the market. For instance, when the delta equals 1, that means the options portfolio will change in value equal to the underlying financial instrument. The same applies for when the delta is negative 1 for a bear market bias.

Finally, delta hedging can become more complicated when the trader factors in the gamma risk. This requires gamma hedging, which is the same idea, only it bases the transactions on making the gamma near zero.

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