Getting the market direction wrong leads to significant volatility for portfolio returns. No one wants to be on the wrong side of a trade.
Investors often choose to be directionally neutral. Whether it is because of a particular strategy or the current market environment, limiting directional risk is important for many investors.
Delta hedging is an options strategy that seeks a neutral directional bias. Investors may target a neutral portfolio for less volatile returns. Plus, no one wants to be on the wrong side of a trade. Predicting the wrong market direction can lead to volatile portfolio returns.
Delta hedging offsets long and short positions in the same underlying security to create a neutral portfolio that is less sensitive to changing market conditions.
What is delta hedging?
Delta hedging is a neutral options trading strategy used to generate income while staying nondirectional.
Delta measures the responsiveness of an option position to the underlying security. Traders use delta hedging to generate income while staying nondirectional or balanced. The goal is to create a portfolio without directional bias because its collective positions are offset.
How to trade delta neutral
Delta neutral is a term used to describe a directionally balanced portfolio.
Delta is the amount an option price should change based on a $1 move in the underlying asset. Delta is constantly changing as the option approaches expiration and the underlying asset experiences movement in price or volatility.
A delta neutral strategy uses all the positions in a portfolio to offset or neutralize one another and achieve a net-zero portfolio delta value.
For example, if a portfolio consisted of one position with a positive delta of 0.50, a new position could be added with a negative delta of -0.50 to create a delta-neutral portfolio.
Traders can also delta hedge an options position by trading the underlying security. For example, if a portfolio has one call option with a positive delta of 0.50, adding a short stock position of 50 shares in the underlying would bring the portfolio back to delta-neutral.
The goal of delta hedging is to keep a portfolio directionally neutral or flat, regardless of fluctuations in the underlying markets. Delta neutral strategies allow investors to capitalize on an underlying asset’s changing time value or volatility.
Investors may seek a delta-neutral portfolio to limit exposure to changing market conditions. Portfolio managers must continuously monitor the portfolio’s assets to maintain delta neutrality because delta’s value is constantly changing as market prices fluctuate.
In practice, a delta-neutral portfolio is nearly impossible without continuous, dynamic trading.
Portfolio delta gives you a good representation of how balanced or unbalanced your portfolio is as a whole. Portfolio delta takes all of your position deltas and the betas of the underlying securities and relates them into a single market position.
For example, if a beta-weighted portfolio delta is 7, then for every $1 that the S&P 500 goes up, the portfolio should make approximately $7.
Typically, traders calculate portfolio delta relative to a benchmark, like the S&P 500, to demonstrate what a portfolio would look like if it consisted entirely of the index.
If portfolio delta is positive, it benefits from an upward move in the benchmark. If portfolio delta is negative, it is “tilted” bearishly. This portfolio-wide perspective allows traders to add or remove positions to balance the portfolio.
A trader with a high beta-weighted delta may want to add bearish exposure to create delta neutrality, lessen exposure to a market downturn, and create a more balanced portfolio.
The goal of delta neutral trading is to be as balanced to the market as possible all the time.