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Hedging with Delta - Options Mastery Series Lesson 9

Filed Under Options Mastery Series 

The third important fact that all stock option traders and portfolio managers should understand about the Greek, Delta, is how to formulate a strategy to help reduce risk. This objective was the major motivation for the develop-ment of stock options.
 
As you know, Delta is one of the many important variables produced by the Option Pricing Model. Delta does three important things: 1) Provides an indication of the probability of finishing in-the-money; 2) Describes the correlation of price movement between options and underlying; 3) Provides ratios for options to stock for risk reduction. Let’s talk about this last topic commonly known as Hedge Ratio.
 
Hedge ratio tells us how many options at a certain Delta we would need to reduce the total position risk to near zero. For example, if we have 1000 shares of a certain stock, how many stock options will we need to buy or sell to offset potential losses of value in the underlying stock? This is an important tool for portfolio managers who want to “lock in” unrealized portfolio gains. Here is how it works.
 
Suppose you have 1000 shares of XYZ stock and you have realized a nice gain over the years. Now, the market seems to be entering a period of correction or there are potential short term problems within the company. To help protect the shares against losses, stock options in the form of long puts or short calls can act to offset potential losses. For out purposes, we will buy puts. But the big question is: How many puts must we buy and at what strike price to protect at a 100% correlation any downward move in price of the underlying stock. In other words, if the stock price goes down, how many puts must be purchased at a certain strike price to gain profits on the options to offset the losses on the underlying stock?
 
One share of a stock has a delta of 1. Its value is in itself. How many options must I buy to produce a Delta of 1? You could buy two options with a Delta of .5 to cover each share or 3 options with a Delta of .34; or 4 options with a Delta of .25. You get the picture. Keep in mind that a long position always has a positive Delta; a short position or a put has a negative Delta. Therefore, to reduce Delta to zero requires offsetting Deltas.
 
To test your understanding, try this example: You have 300 shares of ABC and you want to protect against a downward move. How many options should you buy (or sell) to cover the total downside risk? First of all, how many long Deltas does the position have? How many negative Deltas must I find to offset the long position? How many puts must I buy if I buy an ATM put with a .5 negative Delta or if I buy an OTM put with a negative Delta of .4?
 
Answer: The 300 shares of ABC have total positive Deltas of 300. To offset the 300 long (positive) Deltas would require 300 short (negative) Deltas. If you use the ATM options with 50 deltas (100 shares per contract) you would need to buy 6 contracts of the ATM options. For the OTM options with a .4 Delta, you would need to buy 40 (negative Deltas per contract) and divide that into the positive Deltas of the 300 shares. Thus, you would need to buy 7.5 contracts (round off to 7 or 8). Don’t forget to deduct the cost of the put positions from unrealized gains.
 

In summary, not understanding the power of Delta is to not understand stock options. For more information on the tremendous potential and flexibility of stock options, contact Options University (www.optionsuniversity.com) for a listing of online courses, seminars, webinars and other educational stock option opportunities.

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