All traders begin with an introduction to call and put options. However, it's rare (apart from short puts) that an experienced trader would use these contracts by themselves. Instead, we primarily trade options spreads. There are many benefits to spreads. The variety of spreads are targeted to various market criteria and market environments.
What is Delta Hedging?
One major principle that many of the spread types share is the concept of delta hedging, a technique used to reduce the directional exposure of the underlying stock. This allows us to create lower risk positions.
While many options spreads have built-in delta hedges, the positions delta can still change with price movements by the underlying stock. We can also use delta hedging to maintain the desired delta set at trade entry. This is the more conventional definition and use of delta hedging.
Let’s take a short put as an example: A significant risk to the premium seller is being short gamma. Gamma defines the expected change of delta for a $1 price move in the underlying. While gamma doesn’t affect the P/L of the position outright, it does change the delta of the position. The changing delta exposes the seller to more and more price risk until the position behaves like a long stock position.
Instead of being subject to the markets every twist and turn, we can use delta hedging to maintain a more consistent delta despite price moves. This hedging approach can be applied at a trade level or a portfolio level so long as all the positions in the portfolio are beta weighted to a common reference.
In short, as our position or beta-weighted portfolio delta becomes more negative or positive (whichever is the undesirable direction) we can “balance” the position using Delta Hedges.
So let’s take a look at the various delta hedging methods we have at our disposal.
Delta Hedges in Our Trading Quiver
Here’s a short description (review) of the strategies used for creating positive delta hedges:
How it Hedges: 1 share of stock will provide 1 overall delta to the position. Stock provides “static delta”. Unlike with the use of options in Delta hedges, stock will maintain a delta of 1. It’s important to remember the option contract’s multiple – if the contract is for 100 shares of stock, then a deep-in-the-money option will have an option of “1” which is equivalent to 1x100 = 100.
Trade-Offs: This is the most effective positive delta hedge but is coupled with high capital requirements. Furthermore, while you protect yourself from growing delta as prices increase, you could lose if the price action sharply reverses and your original options position is a defined-risk spread.
How it Hedges: Like stock, the long call will hedge growing negative delta, but with a much lower capital requirement.
Trade-offs: While this hedge is less capital intensive, it is still an expensive delta hedge to hold due to the negative theta from buying the calls. It is important to remember that when putting on this type of hedge, that you are still buying calls regardless of its title of a “hedge”.
How it Hedges: Short puts have a positive delta which can offset any growing negative delta position. The premium received is the maximum protection against price moves.
Trade-offs: This hedge is much cheaper than buying long calls or stock but has limited effectiveness for big price moves and is coupled with increased margin requirements and the commitment to buy the underlying at lower prices.
Long
call spreads
How it Hedges: An alternative to a long call. This strategy involves the buying of a lower strike price call and the selling of a call with a higher strike price than the underlying asset (bullish).
Trade-offs: A long call spread is a great hedge for a range. However, the long call spreads’ delta will reduce to 0 as the price increases past the short call in the spread.
Short
put spreads
An alternative to a short put. With a similar tradeoff as seen between long calls and long call spread s.
… and many others
The strategies used for creating negative delta hedges include: