Importance of Delta Hedging in Options

Posted on March 25, 2013 by Puneet Maheshwari

Delta Hedging Introduction

What is the meaning of risk in the stock markets? Risk is basically defined as loss of trading capital. This means losing money in trading.OPTION TRADING  
always termed as risky mainly because of the nature of stock and index options as they are highly leveraged and option trading risks can lead to huge losses if
managed not properly. So that is the reason why hedging comes into the picture and why delta hedging is a good tool for option traders to minimize their risk.

What is Hedging?
Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or other market or
investment. Delta hedging is a form of hedging.

What is Delta?
The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of derivatives, sometimes it is referred as the “hedge
ratio.” For example, an option with a delta of 0.5 will move half a rupee for every one rupee movement in the underlying stock. Which means,STOCK OPTIONS  
with a higher delta will increase / decrease in value more with the same move on the underlying stock versusSTOCK OPTIONS  with a lower delta value. Delta
hedging involves working with the calculated delta of options.

What is Delta Hedging?

The process of reducing the exposure of an option to the direction of the market. Delta Hedging is accomplished by establishing a delta equivalent long or short
position in the underlying reference against a long or short position in the option (more here).

Delta hedging is important for option a trader who uses complex option positions. If an option trader is planning to make profit from the time decay of his short term
stock options, then that option trader needs to make sure that the overall delta value of his position is near to zero so that changes in the underlying stock price do
not affect the overall value of his position.

India VIX is an indicator of market expectation of volatility in the near term

Option Delta Value Range

Delta of call options can reach values between 0 and +1. Delta orPUT OPTIONS  ranges from -1 to 0. The value depends mainly on the moneyness of the
particular option (in the money vs. out of the money). Delta hedging involves various deltas to get a picture of risk.

Delta and Moneyness of options<

Just by looking at the delta, you can tell if the option is in the money, out of the money, or at the money.

 Far out of the money (OTM) options have a delta close to zero (they hardly move).
 Deep in the money (ITM) call options have a delta close to +1 (they moves almost as much as the underlying’s price).
 Deep in the money put options have a delta close to -1 (they moves almost as much as the underlying’s price, but in the opposite direction).
 At the money (ATM) options have a delta about 0.50 for call and for put  -0.50.

How the option price moves based on changes in the stock price

1. Trader holds a call option slightly in the money with a delta of 0.60 and market price of 18. This call option gives you the right to buy 250 shares in
ABC company for Rs. 200 (the strike price). Let’s say ABC company stock is now trading at 220 (the underlying market price). What will happen if the
stock price increases to 225?
2. The option’s delta (0.60) tells us that when the underlying stock goes up by 1 rupee, the option’s market price will go up approximately by 0.60 paise.
In the example, the stock goes up by 5 Rs. What will be the increase in the option’s market price?
3. 5 rupees times the delta, or 5 x 0.60 = 3. You can expect this option to go up by 3 Rupees. If ABC Company stock goes to 225, the call option will be
worth approximately 18 + 3 = 21.

Calculating your Portfolio’s Delta

We can easily calculate the total delta of the positions by summing up the deltas of individual options. This is the first step towards delta hedging. For example, a
portfolio with the following options:

 2 ITM Long calls with a delta of 0.60

  1 OTM Short call with a delta of 0.35
 1 OTM Long put with a delta of -0.30

The total delta of this position is:

 2 x 0.60 (2 contracts of long calls)

  0.35 (subtract because option is short)
 -0.30 (add because option is long, but the delta is negative because it is a put)
 = 1.20 – 0.35 – 0.30 = 0.55
 A trader can expect your portfolio’s market value to increase by 0.55 paisa for every 1 Rupee of the underlying stock’s price increase. He can use
delta hedging to adjust the total delta of his total portfolio.

Delta Hedging Example: Long straddle position

Let’s say trader has opened a long straddle position by buying a call and a put option on ABC company, both options with strike price of 250. If ABC company is
trading at 250 at the time, both these options are at the money. This is when a long straddle position can be bought for the lowest price and when it makes the
most sense to open it. Let’s look at different scenarios and how delta hedging plays into it.

Long straddle delta at the money is zero

An at the money call option has a delta of roughly 0.50 (if stock price goes up Rs.1, the call option’s price goes up by 0.50 paisa), while an at the money put
option has a delta of roughly -0.50 (if stock price goes up by Rs.1, the put option’s price goes down by 0.50 paisa). If trader holds both options simultaneously,
the total delta of position is the sum of the two deltas, which in this case equals zero.

Stock goes up from the strike price: delta turns positive

If ABC Company’s stock price goes up, the call option trader hold as part of the straddle is now in the money and its delta increases to somewhere between 0.50
and 1.00. The put option is out of the money (if the stock ended up higher than the strike price, the put option would be worthless at expiration). The put option’s
delta moves closer to zero and it is now somewhere between -0.50 and zero.

We again calculate the total long straddle delta by summing up the two deltas (a larger positive number for the call and a smaller negative number for the put).
You get a positive number. For example the call option’s delta is 0.70, thePUT OPTION ’s delta is -0.30, and the total long straddle delta is 0.40. As a result of
the underlying stock price going up, thelong straddle position has become directional. It has a positive delta and its value and your profit increases as the stock
price goes up.

Stock goes down from the strike price: delta turns negative
On the other hand, if ABC company’s stock goes down from the strike, the call option is out of the money and its delta is closer to zero, while the put option is in
the money and its delta is closer to -1.00. The overall delta of the long straddle position is now negative. The long straddle becomes directional, but in this case
it is bearish (the total delta is negative). The further the stock falls, the more negative the straddle’s delta gets, and in an extreme case long straddle can behave
almost like a short stock position.

Delta Hedging Summary

It’s true thatOPTION TRADING  is risky and a trader can lose all his money if he is not managing his option positions carefully. Delta hedging allows traders to
view their portfolio from another perspective and manage their risk. Using this and other various tools can help the trader manage his risk effectively during highly
volatile markets.

Delta Hedging Strategy – Overview

How great would it be to see a profit and loss curve against the underlying is shaped like a U? Where, regardless of market movement, you are always making
money? It’s rare enough to find a profitable strategy so why don’t we start by drawing up a P&L sheet that looks promising to begin with. This is what I’m going to
show you in this post using a strategy called delta hedging.

Now, the basics of Delta Hedging was covered in an earlier post by my colleague Puneet. If you are unsure of what “delta” is and how it works, I suggest you go
through his post so that you have a thorough understanding of the concepts.

Finished reading? Okay, let’s start. The basic premise of the delta hedging strategy is you buy a call option and sell the underlying (in Indian markets, it would
generally be the equity future or index future). When the market goes down, you want the profits of your short position on the underlying to offset the long position
on your call option. Similarly, when the market goes up, you want the profits of your call option position to offset the loss in your underlying. While it may seem that
both of these profits and loss should cancel each other, it’s not always the case.

Delta Hedging on the NIFTY

Let’s start with an example. I will use real market values of the NIFTY from Oct 1, 2013 to show you how this works. I’m going to apply this strategy on NIFTY
futures (expiring Oct 31) and NIFTY Call Option 6000 (expiring Oct 31 also). Both are very liquid contracts, hence easily tradable. First we start by calculating the
delta of the option. To do so, we need the following data points which can be found on the Internet or calculated by yourself.

NIFTY OCT 31 Closing Price / Underlying Price = 5,828.45 (source: NSE Bhavcopy)

Strike Price = 6,000
NIFTY OCT 31 6000 CE Closing Price = 82.70 (source: NSE Bhavcopy)
Time to maturity (31 OCT 2013 – 1 OCT 2013) = 30 days
Historical Volatility – Current IV of 6000 is around 21 (source: NSE Live Option Chain). Historical Volatility of VIX for the past few days seems to be around 24.
(source: NSE India VIX). The present value of NIFTY is between 5,800 and 5,900 and IV generally decreases as strike prices increase. I will use the value of 21.
Risk Free Rate – 7.16% (as per May 31, 2013. source: Macquarie Capital)
Dividend Yield – 1.50% (average of last 30 days dividend yield of NIFTY. source: NSE)

Now that we have these values in hand, we can plug them into an option calculator to get the delta of the option. Option Price has a good calculator that computes
these values easily.

Delta Hedging on 6000CE Nifty

Theoretical price is 81.18 which is quite close to the actual price. Just a note — sometimes theoretical price may be well off the actual price. This all depends on
what value you use for historical delta. If I had used 23% as my historical volatility value, theoretical price jumps to Rs. 93.68 while option delta jumps to 36.8%.
Trading is an art as much as it is a science.

Let’s stick to the value of 35.4%. That means for every 1,000 shares we buy of the option, we need to sell 354 shares of the underlying to be delta neutral. I’m
going to draw out a table to show what happens when the NIFTY moves from it’s present value.
NIFT
Y 5,600.00 5,700.00 5,800.00 5,900.00 6,000.00 6,100.00
Price

Optio 25.37 44.07 71.54 109.23 157.92 217.48

n
Price

Optio (57,331.0 (38,626.2 (11,157.0 26,530.00 75,220.00 134,780.0

n 0) 0) 0) 0
P&L

Nifty 79,957.50 44,957.50 9,957.50 (25,042.5 (60,042.5 (95,042.5

P&L 0) 0) 0)

Total 22,626.50 6,331.30 (1,199.50) 1,487.50 15,177.50 39,737.50

P&L
Showing 1 to 4 of 4 entries

Now that’s a pretty table. Notice that whatever side the NIFTY moves, you are making money. However, before we get excited over this strategy, let’s talk about
risks involved in this strategy.

Time Decay Risk

Sadly, there is never such a thing as free money in trading. Every reward comes with its share of risk. In our strategy above, notice how the profits happen as the
NIFTY moves away from the present value. If it stays put at the same place, then you fall at risk with the time value of the option. Let’s say that today, we bought
1,000 shares of the Call Option and sold 354 shares of the Future. If the price remained the same, then because of time value of the option, the price of the call
option will go down.

Delta Hedging – Value of option 1 day after trading

Your P&L table on T+1 would now look like this:

NIFT
Y 5600 5700 5800 5900 6000 6100
Price

Optio 23.94 42.15 69.16 106.52 155.03 214.63

n
Price

Optio - - - 23,821.9 72,332.9 131,930.5

n P&L 58,755.9 40,548.3 13,535.1 0 0 0
0 0 0

Nifty 79,957.5 44,957.5 9,957.5 -25042.5 -60042.5 -95042.5

P&L

Total 21,201.6 4,409.20 -3,577.60 -1,220.60 12,290.4 36,888.00

P&L 0 0
Showing 1 to 4 of 4 entries

Conclusion
Delta Hedging is a great strategy for high returns, and low risk if you expect the market price to move. You can use this strategy using a timeframe of a several
days. Generally, intraday movement won’t be enough to start making a profit. But remember, you are somewhat market neutral with a delta hedging strategy.

Notes

 Program traders in India use this as a strategy. They put the values we have discussed above into a program. The program watches the market move
and executes the order. However, this does not mean that they have an advantage over manual traders. They still have to figure out what historical
volatility value to use. Knowing what value to use takes practice and observation of historical prices in the market. Whether you do delta hedging
manually or automatically won’t increase your profit or loss without increasing your risk.
 I left out transaction cost in this article to make it simple. Calculating P&L on delta hedging strategies requires you to factor in exchange and
brokerage costs on each leg. Use our calculator here to get an idea.