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October 28, 2011  Fri 2:19 PM CT

Delta hedging is something that we see quite often in institutional trading, but it has become clear that there are many who don't have a good idea of what it is or how to use it.

The delta of an option refers to its sensitivity to changes in the underlying price. It is one of the "Greeks" that come from the option pricing model. There are several ways to look at the delta, but it is most commonly used for hedging purposes.

When you buy a share, the delta is 1--so if the stock goes up, you make $1. Option delta ranges from 0.01 to 1. An at-the-money option usually has a delta of around 0.5. This means that, if the stock goes up $1, the option will gain $0.50.

A delta-hedged position is one in which the trader is removing the initial sensitivity to changes in the stock price. This is foreign to most traders, who usually focus only on the direction of the underlying. 

As an example we can look at recent option activity in Potash. A trader sold 5,000 November 50 calls with POT trading at $48.20. By itself, this would be a neutral to mildly bullish position.

But in the next minute a block of 150,000 shares of POT were bought for $48.07. The delta of the options at the time was 0.30. So the stock trading (+150,000 delta) made the position delta-neutral (5,000 x 100 x -0.30).

Delta-neutral strategies allow traders to focus on potential sources of profit that are not just directional. Those who buy options and delta-hedge them believe that volatility will increase, and they can profit from a sharp move that is either higher or lower. They can also profit if the actual volatility is greater than that implied by the option contract's price.

Option sellers can profit from time decay and/or a decrease in volatility. This latter is not the same as a covered call, and its profit/loss is more similar to a straddle than to a covered position, which faces losses in only one direction.

Most traders that know the difference will tell you that predicting the direction of volatility is easier than predicting the direction of the underlying. Volatility is mean-reverting and bounded, so its charts are typically pretty regular.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Oct. 12. Trade graphic courtesy of tradeMONSTER.)
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