In trading Delta hedging is a way to structure an option play to decrease or even eliminate the directional risk exposure of a stock holding or other option contracts.
Stocks and options have directional exposure to a move in the market price, this is called Delta which is reflected by how much money a position makes or loses on every $1 move in the stock or underlier of an option contract. If an at-the-money call option moves .50 cents for every $1 the underlying stock moves it is said to have a .50 Delta.
A long stock position with no hedge would have a positive 1.00 Delta. A short stock position with no hedge would have a negative -1.00 Delta.
For option plays or stock positions a trader may at times want to lower or remove directional risk exposure. For options it may be to focus on profiting from Theta decay and for stocks it ay be a desire to hedge against losses for long term holdings during market downtrends.
If it is a long position with positive delta then the exposure to directional risk can be lowered by buying negative delta positions to offset the move in some or all of a bullish holding. Like buying put options to hedge a long stock position.
If it is a short position with negative delta then the exposure to directional risk can be lowered by buying positive delta positions to offset the move in the bearish holding. Like buying call options to play bounces in price action around a longer term short stock position.
Positive Delta positions include:
Long stock shares
Long call options
Short put options
Buying calls spreads
Selling put spreads
Negative Delta positions include:
Selling shares of a stock short
Long put options
Short call options
Selling call spreads
Buying put spreads.
Delta hedging is adjusting how much of a trend will be captured by an existing position by adding a new leg to that play.
If a long stock position has an at-the-money put option added to it then the 1.00 Delta the stock has can become a .50 Delta for the exposure as a whole because for every dollar the stock goes down -$1 the put option will go up .50 cents.
If a short stock position has an at-the-money call option added to it then the -1.00 Delta the short stock position has can become a -.50 Delta for the exposure as a whole because for every dollar the stock goes up +$1 the call option will go up +.50 cents.
Delta hedging is a way of changing directional exposure and can even make a trade directionally neutral.
If you own a stock and buy an in-the-money call option with a 1.00 Delta then the stock and option will move dollar for dollar together and only Theta will decay as long as the option stays in-the-money this play would be Delta neutral and profit from any declining Theta value as time went by.
Delta is just one of many options Greeks to consider as it represents how much of a directional move is captures. To save a lot of time and searching you can learn more about the basics of trading options by checking out my Options 101 eCourse.
