Complete Guide to Delta Hedging To Protect Your Portfolio

Delta hedging is the advanced options trading strategy aiming to reduce the risk associated with the direction of the underlying asset's price movement. Some traders use the options to offset the risk. Options contracts can be used to hedge a particular asset or for the complete portfolio. The goal of the investor is to reach a Delta-Neutral state. Upon reaching there, there will be no effect of the price movement on your portfolio. We can understand that Delta Hedging is the process of continuously buying and selling the stock and ETF simultaneously to reach a neutral state.

One of the significant disadvantages of Delta hedging is that the investor must constantly keep an eye on the price movement and rebalance the whole portfolio to ensure that the risk is hedged. This rebalancing adds extra cost by buying and selling the stock to adjust it.

Delta is the ratio of the change in the options contract price in relation to movements of the underlying asset's value. When you are hedging delta using call options, it means that you are short-selling the stock. Hedging using short selling means shorting the stock to an equal number of the delta. Suppose the call option of X stock has a 50 percent Delta value; then the trader has to hedge by selling the 50 shares of X stock.

Suppose the X stock has a delta value of 0.8. It means that the options price will rise by 0.8 rupees per 1 rupee increase in the stock market price. For call options, the value of the delta ranges between 0 and 1, and for put options, it ranges between -1 and 0. When we say that a put option has a -65 delta, it implies that there will be an increase of 0.65 on every one rupee fall. If the delta value of the call option is 0.75, it means that the price will increase by 0.75 for every rupee.

Delta is closely related to the options price, whether they are at-the-money, Out-of-the-money, or in-the-money. However, the traders try to reach delta 0, where there is no effect on your portfolio due to price movements. The main aim of hedging is to get to the delta-neutral stage. You can use the Delta Neutral Options Strategy to reach a neutral state. Your portfolio will not be affected by price increase or decrease at this stage.

Traders consider Delta Hedging Strategies as one of the complex strategies and only used by some institutional investors or giant/experienced companies. As everything has pros and cons, even delta hedging has its.

Advantages of Delta Hedging:

• It helps traders prevent the risk related to constant price variations in the stocks they hold in their portfolio.
• It helps in getting short-term profit by using options along with holding the positions for a longer term.
• Using the delta hedging strategy, your portfolio can reach a minimum breakeven point where the losses are minimal.

Disadvantages of Delta Hedging:

• Traders have to monitor closely
• Based on the volatility, constant buying and selling of the stock are involved.
• Avoid over-hedge or under-hedge situations.
• As it involves buying and selling, it incurs transaction costs, and the whole trade can be costly.
• It is very time-consuming and requires a lot of concentration.

How does the Delta neutral strategy work?

If a trader positions an asset for long positions, it has a delta value of 1 or near 1. And if it is a short position, the delta value is around -1. When the trader combines the long and short calls with long and short puts in a way that the delta value becomes 0, this stage can be said to be a neutral stage.

Many traders have a question in their mind, is this strategy profitable?

Delta hedging helps traders predict the change in the underlying stock price. But there is always a fear of under and over the hedge because of the prediction of price variations. Apart from that, you must pay transaction fees for every move you take to hedge your portfolio. We recommend using Portfolio Management Software for Indian Stock Market or taking advice from an expert. If you think you can do this on your own, you might end up paying the transaction cost every time. So it's better to rely on someone who is more experienced and can give accurate details; may it be software for portfolio managers or some hedging expert.

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Kalpesh is a experience content writer having vast experience in writing articles of various fields like health, finance, education, textile etc.