Other Hedging Strategies with Options

Delta Hedging

Delta hedging is an options strategy that aims to reduce, or hedge, the risk associated with
price movements in the underlying asset, by offsetting long and short positions. For example,
a long call position may be delta hedged by shorting the underlying stock.

 Delta hedging is a strategy based on option’s data. The delta of an option is the ratio
of change.

 If the delta is 0.50, the option premium will change by 50%for the change in the price
of the stock.

 The minimum variance hedge ratio is the reciprocal of the option’s delta. If the delta
is 0.50 then the hedge ratio will be 2. As an option’s delta changes, the hedge ratio
also changes.

 The delta is the slope of the curve that relates the option price to the price of the asset.

∆=∆C/∆S

Example:

An investor has sold 20 option contracts to buy 2000 shares. Suppose the option price is Rs10
and the stock price is Rs100 per share. Assume a call option whose delta is 0.7. the investor
wishes to hedge the position.

The investor will immediately buy 0.7×2000=1400 shares. The gain on the option position
would tend to be offset by the loss (gain) on the stock position.

If the stock price goes up by Re1, then the stock will produce a gain of Rs1400 on the shares
purchased , the option price will tend to go up by 0.7×1=Rs0.70, again producing a loss of
Rs1400 on the option written and vice versa.
OTHER CONSIDERATIONS IN DELTA HEDGING

 The movement of the stock price would tend to change the value of the delta, so a
delta changes must be constantly monitored and the number of options increased and
decreased in the light of changed circumstances.

 Since adjusting the hedge ratio can entail substantial transactions costs in a volatile
market, so it should be properly examined.

 There are other factors which cause to change in the opinion’s value like time
remaining expiry date, expected volatility of the stock price, etc.

DELTA OF A PORTFOLIO

When a number of options on an underlying asset are held, the delta of the portfolio is then
the sum of the deltas of the individual options in the portfolio.

Example:

Consider a firm which has the following three positions in options to buy or sell US dollar:

 A long position in 1, 00,000 call options with strike price Rs45.00 and expiration date
in three months. The delta of each option is 0.533

 A short position in 2, 00,000 call options with strike price Rs45.20 and expiration date
in five months. The delta of each option is 0.468.

 A short position in 50,000 put options with strike price Rs45.20, and expiration date
in two months. The delta of each option is 0.508.

The delta of the whole portfolio is:

0.533×1, 00,000-2, 00,000×0.468-50,000× (-0.508) = -14,900

THETA (θ)

 The expected change in the option premium from a small change in the time to
expiration is termed as theta.

 It is calculated as the change in the option premium over the change in time.
 Thetaθ=∆Premium/∆Time

 Theta is almost always negative

 The option premiums deteriorate at an increasing rate as they approach expiration.

Most of the option premiums, depending on the individual option, are lost in the final
30 days prior to expiration. The exponential relationship between option premium and
time is seen in the ratio of option value between the four month and the one month at
the money maturities. It will be

Premium of four months / Premium of one month=√4 / √1=2

 Similarly, a six month option’s premium is approximately 2.45 times more expensive
than one month.