Delta Hedging

Delta - Revisit Again

Delta Hedging



In the above example of positions in IWM, there is a net +ve 9.65 deltas (let's just round this off to +ve 9).

This simply means that, at that juncture, if IWM rallies 1 point (meaning $1), this position will gain 9 cents or if IWM drops by $1, then this overall position will lose 9 cents.

Suffice to say that, a trader must watch the overall delta figure. If the delta of this IWM shoots up to 1000, then for every $1 movement of IWM, the portfolio will either win or lose $1000.

Now for the concept of delta hedging.

A trader may decide to hedge this above investment portfolio when the overall delta position becomes too large. Supposing, that the IWM options portfolio above went from +ve 9 delta to +ve 200 delta, which means this trader will win or lose $200 with every 1 point movement in IWM shares at that new delta figure.

Decidedly, this is too much of a risk for this trader to stomache. He can take either of these actions :

a) cut down the position size of his options, either by closing off bullish positions or adding on bearish positions, which will generate -ve deltas. as a result, this +ve 200 delta will be reduced.

b) Short IWM stocks. for every 100 shares of IWM that he shorts, he will accumulate -ve 100 delta. ONE Long share of IWM has corresponding ONE +ve delta, so ONE Short share is ONE -ve delta.

If he wants to reduce his delta overexposure by 100, then he could Short sell 100 shares of IWM. He will then bring his overall delta down to +200 from +100. This technique is known as Delta Hedging.

But delta changes all the time; it never stays static, not unless the underlying freeze in price movement.

Therefore, delta hedging is cumbersome, involves high overhead costs and is usually only practiced by professional traders/fund houses/floor traders, where the commission fees are markedly lower to non-existent.

So, the purpose of this writeup, is only to highlight that deltas change and for many reasons. In this case, deltas can change because the underlying IWM price changes. However, it is important to note that deltas can and will change, even when IWM price remains relatively unchanged. Deltas change with the passage of time and Implied Volatility.