Investing > Complete Guide to Delta Hedging

Complete Guide to Delta Hedging

When in doubt, look at your option’s delta and prepare to hedge your losses. Here's how.

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Updated August 04, 2022

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What happens in a trader’s head when they see that their option contract has become worthless?

From experience, we can tell you that a dark cloud forms inside the trader’s cranium and starts raining on the brain—metaphorically, of course. This is unfortunate because there is absolutely no way in a million years that an options trader won’t suffer a bucket load of losses throughout their career. Therefore, rainy days are simply part of the job. ☔

However, this symbolic rain cloud can be counteracted with an umbrella—and traders call this the delta hedge. The idea behind this hedging method is to keep an eye on your option’s delta, which is the ratio at which the price of the option will move in reaction to the movements in the underlying asset.

For example, if the FED decides to take hawkish measures, this news alone can turn a bullish market into a bearish one overnight. If a trader is caught in a situation like this with a call option, they can bet on the opposite outcome as well and offset some of the losses.

However, if the trader reacts to every price movement by opening a counterposition, they can fine-tune their trade into something ranging from not bad to very profitable—and this can all be done by watching the option’s delta.

As options often are, the delta hedge is a bit complicated, so we’ll take it apart piece by piece and see how it works, what its possible outcomes are, and how realistic a method it is for traders who are not institutional professionals.

Let’s dive in. 👇

What you’ll learn
  • What is Hedging?
  • Delta Hedging Explained
  • Possible Outcomes of Delta Hedging
  • Delta Neutral Position
  • Example of Delta Hedging
  • Pros and Cons
  • Conclusion
  • Get Started with a Stock Broker

First of All: What is Hedging? 👨‍🏫

Even pro traders don’t win all the time or even most of the time. In many cases, they make many more bad trades than winning trades overall—so how do they manage to make a buck by the end of the day?

Pros know from experience that despite all technical analysis and macroeconomic studies, some markets are chaotic and fundamentally unpredictable—especially in short time frames that day traders work in. Therefore, the only way to approach the market as an active trader and still make money is to make every inevitable loss as small as possible.

Essentially, if you bet on a stock using a call option and the price starts going down, you can react by shorting the stock and profiting from its sudden downward move. In essence, you bet on both outcomes, so regardless of what happens, one of your bets will win and the other will lose—this won’t make a lot of money, but it also won’t incur a loss either and your portfolio will be much, much better off in the long-run.

Delta Hedging Explained 📚

Delta hedging is when a trader hedges their short or long position by betting on the opposite outcome. In option’s nerd terms, the trader will seek to move the delta of their option in a direction that will make their bet profitable (in-the-money)—and if that is not doable, they will seek to reduce the delta in order to minimize the losses of their bet. Here is how this works:

What is Delta? 🤔

Delta is a letter in the Greek alphabet and is also very important to options traders because it tells us how much an option’s value will be changed by the movement in the underlying asset’s price. Here is how it works:

Delta can range from -1.00 to +1.00—if a call option has a delta of +0.60, that means that if the underlying stock’s price moves up by $1, the value of the option will increase by $0.60. On the other hand, if a call option’s delta is -0.60, that means that the option’s value decreases by $0.60 if the underlying stock’s price drops by $1. 

Naturally, as far as put options are concerned, a positive delta is correlated to a decrease in price and vice-versa because put options are short positions that become profitable when the underlying price drops. Essentially, a trader buys an option and if the option’s delta goes too close to zero, the trader will suffer a loss—and that’s when hedging becomes necessary.

Why is Delta Important to Investors? 📕

Considering how complex options and the stock market are, it is incredibly useful to be able to express an option’s characteristics using a number. The delta formula produces a single number that tells us exactly how much an option would be worth if sold—this makes risk analysis easier for options traders.

Also, delta can be used to gauge how much a position needs to be hedged in order to reach a break-even point. An option with a very low delta will require a stronger hedging counterposition than an option with a delta of -0.1, which means that delta is a very useful metric in all facets of options risk management.

💡 Keep in mind: The selection of available options on your trading app is crucial for fine-tuning and hedging any options trade, which is why the top options trading brokerages are the go-to for most day traders.

How Delta Hedging Works 👷‍♂️

First of all, it is worth noting that delta hedging can be very complicated and technically advanced—this is why it is mostly used by professional institutional traders with a lot of trading capital. So, let’s take delta hedging apart piece by piece. 

Let’s say a trader named Tom buys a call option for Crocs (CROX) stock—he is betting that CROX will go up in volume, and the option will allow him to buy 100 shares of the stock at a low price when its expiry date comes (if his prediction is right). Now, Tom is watching the stock chart for CROX, and eagerly awaiting a swing up.

As Tom is waiting for the summer months when Crocs usually sell very well, something unexpected happens and the whole market gets turned upside-down by the conflict in Ukraine. Namely, the stock market has dropped and doesn’t look like it will rally because the conflict is making investors uncertain and bearish.

The delta of Tom’s call option is very low, and he will likely lose money come expiry date—but Tom really likes money, so naturally, he wants to lose as little as possible. So, he decides to hedge his position by short-selling CROX. 

If Crocs stock keeps moving downwards, Tom will make money from his short position and offset the losses created by his call option. On the other hand, if the markets regain their zeal and start seeing the great inherent value of rubber beach shoes with big holes in them, they might start buying again and Tom’s call option will become more profitable.

All in all, Tom wins either way but he also loses either way. The worst-case scenario is: Tom will limit his losses a little bit. However, the best-case scenario will unfold if CROX goes up or down a lot—if the stock moves up, the call option will become profitable enough to eliminate the losses caused by the short position and vice-versa. 

Delta Hedging Possible Outcomes 📃

As is the case with all options trades, there are only 3 possible outcomes to a delta hedge trade: In-the-money, out-of-the-money, and at-the-money. In human language, this means profit, loss, and break-even. Let’s take a look at all 3 scenarios and how they relate to delta.

In the Money (ITM) ☑

A call option can have a delta ranging from 0 to 1, and a put option can have a delta ranging from 0 to -1. Simply, the further the delta is from 0 in both cases, the more the option’s price will react to the underlying asset’s price.

If a call option has a delta higher than 0.50, only then can it be sold at a profit. This is simply because a call option that has a delta of exactly 0.50 has a strike price that is identical to the underlying stock’s current price. Naturally, a put option needs to have a delta lower than -0.50 to be profitable.

At the Money (ATM) ☑

When the strike price of an option is exactly the same as the price of the underlying stock, that is an ATM option. If an option is at-the-money come expiry date, it cannot be used to turn a profit—therefore, it is not profitable.

Namely, every option contract has a fixed price called a premium. The premium is paid in advance by the trader purchasing the option, and unless the trader can make a profit greater than the option’s premium, the trade will not be profitable. A call option with a delta of 0.50 and a put option with a delta of -0.50 are ATM, which means they can’t be used to acquire or sell the underlying stock at a preferable price.

Out of the Money (OTM) ☑

Simply put, an OTM option is the worst kind to have because its strike price is less preferable to the trader than the underlying stock’s current market price. The options contract itself cannot be sold at a profit but a trader who owns it might be able to sell it before expiry at a loss in order to offset some of the total losses of their trade.

A call option with a delta lower than 0.50 and a put option with a delta higher than -0.50 are both OTM, which means that they are unprofitable—that is, unless the delta changes over time. When an options contract turns out to be OTM, that’s when a delta hedge becomes handy.

Namely, if trader Tom is watching the delta of the call option he just bought go further and further as the expiry date approaches, he can short sell enough shares of the underlying stock to make sure that his short position will make a profit that will cover the losses created by him buying the call option. Covering the cost of the option’s premium—at least to some extent—is crucial because these small protective measures can add up over time.

Diving Into the Delta Neutral Position 🤿

Everything is in motion always, including atoms, planets, entire galaxies, and probably most of all, stock prices. But options traders aren’t interested in galaxies—what they want is that their options become more valuable than their underlying stocks. That way, they can be sold at a profit.

When an option has a neutral delta, that means that its price is not moving in relation to the underlying stock’s price. Essentially, a delta neutral position is when an option is worth exactly the same as the underlying asset—therefore, a single option is worthless to the trader if it is in a delta neutral position come expiry date.

Example of Delta Hedging 📝

First of all, if we want to use a delta hedge, we need to see what its strengths are and play into them. As we discussed, a position hedged using even the simplest delta hedge will benefit from high volatility—if prices go up or down enough, one of our positions (long or short) will become lucrative enough to completely cover all expenses and leave us with a profit.

In order to do this, we can buy an option with a long expiry date of a few months or even a year, and we need an asset that will likely demonstrate a few significant price changes within that period. So, let’s use the S&P 500 ETF called SPY as an example. Keep in mind that SPY vs. SPX results in a number of differences.

On average, the stock market as a whole (and thus the S&P 500) goes up roughly 70% to 80% of the time, but pullbacks of 5% to 10% occur 2-3 times a year. So, if we bet on the stock market and let our assets sit idly for years, we will generally make a profit.

However, if our portfolio gets hit by one of the recessions that happen roughly once every few years, that means our portfolio will likely need a few months to a couple of years to get back to the status quo. Naturally, it pays to avoid situations like this, so we must prepare either by investing in recession-proof assets or by hedging our bullish positions.

So here is what we will do for this simulated scenario: We will buy a call option for SPY on the 1st of January 2020 and we will prepare for a downturn by buying shorting SPY. Since this article was written after 2020, we know exactly what happens, so let’s see how our strategy would’ve worked if we executed it back then.

The SPY Delta Hedge Strategy 📈

On Jan. 01, 2020, a share of SPY cost $324. First, we buy a call option for SPY with a 1-year expiry and this costs us about $200. Then, we short sell, say, 50 shares of SPY—straight away, we get $16,200 for our short sale which we will lose if the ETF doesn’t lose value. Then, we wait to see what will happen.

Chart depicting SPY’s lowest point in 2020, $220, and its heightened position at the end of 2021 ($368)
At its lowest point in 2020, SPY was at $220, and at the last trading day of the year, it was at $368—a full $44 above its Jan. 01, price. Image by TradingView.

Up until February 14, we have been losing money from our short positions but after the COVID-19 crash, we are able to buy up shares at a low cost and cover our short position, making a few grand in the process. This is good news for us but it is also a fork in the road.

Two things can happen now: The market can continue to plummet because the economy has been decimated by the pandemic or it can rally, encouraged by FED’s dovish policies.

If we are bullish, we can use the capital we gained by shorting all those shares to buy up more, expecting to turn a profit when the market rallies—and if we’re bearish, we can short some more shares.

However, if we want to keep things simple and safe, we can just do nothing—even if our call option fails, we still made some money by shorting SPY shares, so we will end up with a profit. Luckily, as we know, the market rallied, which means our hypothetical call option made roughly $4,400 by the end of the year. 

This form of hedging is the simplest, most rudimentary version of the delta hedge—we only made one bullish and one bearish trade, and since the markets were volatile in 2020, it paid off. Now, if the markets were passive and showed no upward or downward movement, our hypothetical trade would have left us with a loss of a few hundred dollars—the call option’s premium plus a small possible downturn from failed short sales.

Pros and Cons of Delta Hedging ⚖

The first thing worth noting is that delta hedging is mostly used by institutions and pro traders. This is because a full delta hedge involves buying and selling the underlying stock or exchange-traded fund (ETF) as many times as necessary to make sure that the delta of our position is preferable by the time our option expires.

This sounds simple on paper but may involve dozens of trades, each costing money, and each incurring brokerage fees—unless you’re using a zero-commission brokerage. Moreover, in order to be comfortable with performing a delta hedge like this, a trader must have a very sizable trading balance to fall back on. This is far more common with financial institutions than with individual retail traders.

Moreover, because so many consequent trades are needed to complete a delta hedge, the only people who can hedge like this regularly are investors who’ve met all of FINRA’s requirements for becoming pattern day traders. However, if all conditions are met, delta hedging can be very powerful for work-at-home day traders.

It is also possible to do a simplified delta hedge—just one or two trades to offset some of your potential losses. If used like this, delta hedging isn’t a complicated strategy and can create value for a mindful trader.

All in all, as a strategy, the delta hedge can get very technical, complicated, and expensive if a trader decides to execute it as institutional professionals do. However, applying a partial delta hedge to a trade that got turned upside down because of some recent news—like NKLA’s 2022 Q1 earnings report which suddenly made the EV manufacturer seem like a very legit company—is a great way to minimize losses or even squeeze out a profit from a trade gone bad.

Final Word: Is Delta Hedging for You? 🏁

If you don’t consider trading your day job or you just value not spending time in front of a computer screen, using the full power of the delta hedge is probably not an option. This is simply because this strategy requires watching your position like a hawk and executing one trade after another to make sure that your delta is right where it needs to be at all times. 

However, even though it cannot really be called a delta hedge, more casual traders can take inspiration from this method and use an option’s delta to keep track of its performance. A trader reacting to changes in an option’s delta can turn a completely failed trade into an acceptable loss or even a victory.

What is Delta Hedging?: FAQs

  • What Does Delta Mean in Hedging?

    Delta is a coefficient that represents the change in the value of an option in relation to the underlying asset. When hedging options, traders often aim to decrease the delta of their entire trade if the price of the underlying is going opposite of the direction they expected, thus minimizing directional risk.

  • Is Delta Hedging Profitable?

    Delta hedging has a high probability of being profitable if done right. However, delta hedging is very complex and is difficult to do properly which is why it is mostly used by professional traders in financial institutions. Moreover, a delta hedge requires a lot of capital because of the sheer number of trades that need to be completed in order to maintain a preferable delta level throughout an option’s lifetime.

  • How Does Delta Hedging Make Money?

    A delta hedge is used to minimize losses due to a change in the direction of the price of an option’s underlying asset by betting on both directional outcomes in a specific way. For example, if a trader is long a stock but takes precautions and shorts the while waiting for their option’s expiry date, the trader will make money as long as the underlying price moves enough in either direction.

  • How Do You Hedge With Delta?

    If we are long a stock, the delta of an option is high, and the underlying stock is losing value, the option will be out-of-the-money, ergo, it will result in a loss. To counteract this, a trader can short a stock if it starts moving downwards, bringing the total delta of the two positions closer to zero, minimizing losses if they occur.

  • When Would You Use Delta Hedging?

    Delta hedges are typically used in scenarios where an option’s delta moves in the direction opposite of that which the trader expected. By entering an opposite position, a trader can protect themselves from losses caused by the underlying price moving in an unfavorable direction—in essence, a delta hedge removes directional risk from a trade.

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