Delta hedging is the practise of setting opposed risks opposite each other, so that the net weighted risk is diminished. When positive and negative delta components offset each other perfectly, the portfolio is not very sensitive to changes in the value of the underlying asset which was used to calculate delta. This kind of portfolio is called delta neutral.
What is delta?
Delta represents the rate of change of option value, relative to changes in the underlying asset’s price. It is one of the first derivative risk sensitivities, or Greeks, and the most commonly used derivative among the Greeks.
Using delta is an easy way to represent how a portfolio or part of a portfolio will behave, relative to the base asset. A portfolio which is comprised only of the base asset must have a delta of 1.0. Long calls always have positive deltas, while long puts always have negative puts.
Deltas for basic portfolios which only have a single type of financial vehicle range between 1.0 and -1.0, although deltas for more complex portfolios can exceed these numbers. Deltas for more complex portfolios can be calculated by adding together the deltas for each part of the portfolio, as long as all the parts are based on the same underlying asset.
Basic delta hedging
The delta calculation measures the equivalent of the portfolio’s behavior in terms of its base assets. Once this number is known, the simplest form of delta hedging would require buying or shorting that number of shares, to make the total delta of the portfolio come out to zero. This is a delta neutral portfolio.
Problems with delta hedging
Delta hedging does have risks. Trying to hedge against large movements in the price of a financial vehicle can magnify losses. Even in a low-volatility market, continually delta hedging a portfolio will result in lower cash flows in that portfolio. For these reasons, most investment groups limit their total amount of data hedging.
Traders are usually required to keep their risk limits within a low delta limit, to restrict the potential losses. However, there are built-in delays to most trades, which can be abused.
An easy way of circumventing the delta limit and making the total delta seem lower than it really is is to book in a dummy trade to offset the high delta. Dummy trades are commonly used when the electronic ticket is slow in coming, so that the trader can see immediately what the trade will do to the total delta. This enables the trader to make other decisions based on the new delta, without having to wait until the electronic ticket arrives to make other decisions.
Normally the dummy trade is canceled and replaced by the real trade when the electronic ticket arrives. However, there is nothing stopping a trader from booking in a dummy trade when there is no equivalent real trade. The built-in time delay could give the trader several days before the other shoe drops. In fact, as long as the underlying assets continue to change in value in the expected direction, the company may never notice just how high its delta has grown. If the other shoe ever drops, the resulting loss can destroy the company.