Delta Hedging Strategies Explained
Delta hedging is all about removing directional risk in your portfolio or trading position.
But how do you make money without taking a bet on direction in the stock market?
Delta Hedging – Explained
Before I talk about this as a trading strategy, it is very important you understand what it means to be delta neutral, or delta hedging.
Delta measures the total exposure you have to the market, or product you trade.
Therefore, if I have 100 shares I am said to be long “100 deltas”.
Alternatively, if I own 1 Apple call option contract with a 0.50 delta, I am said to own “50 deltas”.
Whether I own 100 shares or 2 of the above Apple call options, I have an exposure of +100 deltas.
But what if I want to be short as a trader?
If I own 1 put option contract with a 0.50 delta, I am what’s called “short 50 deltas”.
This is also represented as -50 delta.
So let’s assume I own 100 shares of Apple and 2 put options of 0.50 delta.
What is my delta?
If you said 0, that’s correct.
I have no exposure to Apple share movement with the above holdings. Therefore, I am what is called “delta neutral”.
Overall I have executed my delta hedging goal.
Delta Hedging – When is it Useful?
Let’s go over a very simple example to understand.
Assume I am a trader, and purchased 100 shares of Apple at $181 average cost in late June.
Because I own 100 shares, I am now long 100 deltas.
Every time Apple moves $1, I will make $100 on my total position.
As per the chart below, Apple stocks are currently trading at $222.22.
Therefore, my overall unrealized profit is $41.22 per share. ($222.22 – $181.00)
But I own 100 shares, meaning I have an open profit of $4,122.
At any moment I can lose this profit if Apple share prices get hit.
So if I can purchase -100 deltas of protection, this will bring my next exposure to 0 delta.
As a trader, I now need to find put options to get me to -100 delta to buy.
Hence, once I add them to my portfolio I have accomplished delta-hedging.
Any losses due to price decreases in Apple shares will be offset by gains in my long Apple puts.
Delta Hedging – Apple Example
I am going to pull up the Apple options chain using Interactive Brokers, the platform I use for all my options trading.
Now I need to decide how long I want to protect myself. I am gonna choose the next 22 days.
Below is a list of the closest put options to the market price that expire in 22 days.
Looking at the 7th column to the right, you will see “DELTA” at the heading.
Now I will choose the closest contract to -0.50, which is the $222.50 put at -0.505.
How many contracts do I need to purchase if each gives me -50 deltas and I need to offset 100.
In order for delta hedging to work, I will need to purchase two $222.50 Apple puts (22 days to expiry).
This gives me a grand total of -101 deltas.
My delta hedging position is now complete.
Delta Hedging – How do you Profit?
Well, the point is that you do not lose money in a downturn.
Losing less means that you are making more. This is one of my favorite trading psychology hacks for new traders.
The point of initiating this trade is to protect existing profit and to shelter yourself from adverse moves.
Hence, delta hedging with options is best for a stock that is running up against resistance.
Or if you fear a market news event (like midterm elections), but you still want to hold Apple for the long term – or any other stock.
The fact is that institutional traders actively take advantage of delta hedging so they don’t have to sell their long portfolios.
However, there is one way to actually profit with delta hedging – if your stock continues to rise.
You need the stock to go higher than what you paid for your put protection in order to keep making money.
But most importantly, delta hedging is all about protecting profits.
This is a defensive strategy.
Delta Hedging Strategies – Why they Can Cause Massive Moves Higher
Gamma hedging is a more complex matter that I will tackle in my next article.
However, let’s go through a brief example now.
Imagine that I actually have 100 long shares that are delta neutral (through delta hedging) with put options.
What happens if the market starts moving higher rapidly?
I am not making money because I have 0 deltas and no directional exposure. In fact, the first stages of an up move just pay for my put option premium.
So what institutional traders do is rush in the market to buy more delta – long more stock.
If they are futures trader, they go out and buy more futures. Stock traders buy more stock.
This is how a break out plays out and sucks in a lot of buyers as they chase the move higher.
Part of this is due to delta hedging positions being unwound. Another part is gamma hedging, which I will teach you next time.
Delta Hedging Strategies – Is this Useful for You?
If you are a longer term investor who owns a portfolio of stocks, delta hedging is an amazing defensive strategy for you.
You can own stocks for the long term, and protect them with puts so you can sleep at night during down markets.
Additionally, swing traders looking to protect profits for any life of their open positions can also use delta hedging.
If you are outright speculating or day trading, this is not a very useful strategy.
However, even for you it can pay huge gains if you know “why” delta hedging can move markets.
I want to wish you good luck trading.
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.