Eliminating Direction | Delta as a Hedging Tool
May 2, 2016
You’ve probably heard us talk about our total deltas on tastytrade. If not, turn up the volume. When we talk about delta, we are essentially discussing directional risk. As deltas grow larger, directional risk increases. To neutralize that risk in our option positions, we can use shares of stock to hedge our deltas.
Delta is a measure of share equivalency. One share of stock has a delta of one. Long 100 shares equals 100 deltas. Short 100 shares equals -100 deltas. An option with a delta of 1 (-1) is equivalent to 100 (-100) shares of stock (remember: each option contract leverages 100 shares).
A position of 100 shares in a stock will fluctuate by $100 for every $1 that stock moves. Delta conveys how much an option’s price will fluctuate for each $1 change in stock price. An option with a .50 delta will move half as much as changes in a stock’s price. For example, an option trading for $1 with a .50 delta will move $0.50 for each $1 the stock moves.
To hedge options against changes in price, we simply need to buy (sell) shares equal to position delta. For example, if we are short a call option giving us a delta of -25, we can buy 25 shares of stock to offset risk (assuming volatility, time and gamma remain constant). If we are short a put with a delta of 1, we can sell short 100 shares of stock to neutralize our position.
Option delta is not static. When the price of an underlying changes, so too does the delta of an option. Depending on the level of risk desired, we may adjust our deltas. It is common to see what began as a delta neutral position take on directional exposure as a stock’s price changes. That’s okay. We are not delta neutral traders. In fact, we almost always have some directional risk. Where tastytrade differentiates itself is in our use of delta to keep risk at an acceptable level.
Delta hedging is one of the most important trading concepts. It quickly lets us know our directional exposure. Using various hedging techniques allows us to control how exposed we are.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Best Practices: Eliminating Direction | Delta as a Hedging Tool: April 18, 2016
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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