In my last post on this topic, "Why Delta Hedging Matters,"
I argued that an essential aspect of options trading is hedging away
unwanted risks. For most traders, the unwanted risk is usually to
directional price movement, or delta risk. We discuss this issue in
the context of trading iron condors a fair amount on the members area
of the site, but the principle is just as important whether you’re
short one call contract or managing a book of hundreds of positions.
Again, the motivation for hedging away some or all of your delta
exposure is if the purpose of your trade(s) is to gain exposure to
changes in volatility, rather than price.
Delta hedging is the practice of buying or selling options and/or
the underlying asset in order to reduce the net deltas in an open
position. For example, let’s say we had the view that implied
volatility in August XLE options was overpriced and that we therefore
wanted to be short that volatility. (I don’t have a view on XLE either
way at the moment; this is just an example.) The August XLE 45 call is
at the money and has a delta of about 50; if we were short two of those
calls, our net delta would be about -100. In order to delta-hedge the
position, we would buy 100 shares of XLE at the current price. Let’s
say we did all of those things at once – we bought the shares and sold
the calls all at the same time, giving us a nearly delta neutral
opening position.
Because all options have some gamma – because the delta of an option
changes in response to changes in the price of the underlying – that
initial hedge is only the first step. As the underlying moves around
over time, the net delta of the position will change as well. The
obvious response to any changes would be to adjust the hedge
continuously, buying and selling the underlying asset tick-by-tick in
order to stay completely neutral at all times. But that’s not possible
for several reasons: transaction costs would eat up any profits,
contract sizes might prevent sufficiently granular hedges, and the
discrete nature of market prices means a continuous hedge is as
impossible as counting all the real numbers using only the natural ones.
Hedging continuously represents one extreme approach: the other extreme
would be to never hedge, or to do so infrequently. So the key to
dynamic hedging is to navigate the two extremes, avoiding undue delta
exposure on the one hand while keeping transaction costs as low as
possible on the other.
Here are some methods of delta hedging to consider.
