Delta Hedging
AdvancedDelta hedging is a strategy of offsetting the price risk of an options position by taking an opposite position in the underlying asset, sized according to the option's delta, so that small price movements have little effect on the overall position.
An option's delta shows how much its price changes when the underlying asset's price moves. By holding the right amount of the underlying asset, a trader can make the combined position roughly neutral to small price changes.
For example, a market maker sells 10 call option contracts, each covering 100 shares, so 1,000 options in total, with a delta of 0.60. To hedge, they buy 600 shares. If the share price rises slightly, the loss on the options is approximately offset by the gain on the shares.
Because delta changes as the share price moves and time passes, the hedge must be adjusted regularly. If delta rises to 0.70, the trader buys another 100 shares. This continuous adjustment is called dynamic hedging.
Delta hedging is used by options market makers and banks to manage the risk of options they sell. It is not perfect: frequent adjustments incur trading costs, and sudden large price jumps can cause losses before the hedge can be adjusted. Gamma measures how often adjustments will be needed.
For worked examples and full lessons, visit notesbysara.org.