Delta Hedging - Meaning, Application, Pros and Cons

Risk management is a crucial aspect of options trading and delta hedging is among the several hedging strategies in options. Understanding the concept of delta hedging can help you reduce exposure to price fluctuations and achieve a stable portfolio performance.

What is Delta Hedging?

Delta hedging is a method through which you can limit or bring down the directional risk involved with the underlying asset's price movement. The main aim of a delta hedge strategy is achieving a delta-neutral state.

Assume you hold a call option on a stock that has a delta of 0.5. Here, for every ₹1 movement in the stock's price, the option's price would change by ₹0.5. If the stock's price rises to ₹2, the option's value would increase by ₹1.

To create a delta-neutral option trading position, you would require to offset the delta of 0.5. To achieve this, you can take a short position in a manner that the gains and losses in stock and options cancel out each other.

How Does Delta Hedging Work?

Here's how a delta hedge strategy works:

• Calculate Delta

To put delta hedging into work, you first need to calculate delta. Delta is the ratio of change in the options contract value relative to the change in the underlying asset's price.

• Adjust Positions

Once you know the delta, you need to adjust the position in a manner to neutralise it and bring it close to zero. When you do this, when a stock price rises, the gain in options will make up for the losses in your stock position. This helps create a hedge.

• Keep Adjusting Regularly

As the delta changes with a change in stock price, you need to adjust your position and continuously maintain a delta-neutral stance.

Applications of Delta Hedging

You can apply delta hedging strategies in options in various scenarios. Some of the common ones are:

• Mitigate Risks in Options Trading

Delta hedging is widely used to limit fluctuations in the underlying asset's price. For example, you can balance your exposure through delta hedging if you hold call options on a volatile stock.

• Guard Against Unexpected Losses

Delta hedging can help you protect your portfolio against unexpected stock movements. By implementing a delta-neutral option trading position, you can protect against unforeseen losses.

Pros of Delta Hedging Strategies in Options

Some potential benefits of delta hedging strategies in options are as follows:

• Avoid Large Losses

In uncertain and volatile markets, delta hedging can help you avoid significant losses if stock prices experience a sudden and unexpected swing.

• Highly Adaptable

The delta hedge strategy is highly adaptable, as you can change your position based on market developments and changes in stock prices. This lets you finetune your strategy per your risk tolerance and market views.

Cons of Delta Hedging

Delta hedging also has certain disadvantages. These include:

• Requirement for Frequent Adjustments

Maintaining a delta-neutral option trading position warrants frequent adjustments. This can be quite time-consuming and complex to execute.

• Higher Transaction Costs

Every adjustment to maintain a delta-neutral position involves a certain transaction cost. These costs can add up with time and might erode your returns.

Conclusion

Delta hedging is a sophisticated strategy that can help you mitigate risks in options trading. That said, before its implementation, it’s vital to factor in your goals, market outlook and risk tolerance. If managing complex positions isn’t an issue, you can opt for this strategy. On the other hand, if you find it difficult, you can opt for simpler hedging strategies in options.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.