Wednesday, 1 June 2016

Delta Neutral methodologies in option delta hedging technique

Let us first understand what a Delta hedging technique is.

It is an options strategy that aims to hedge the risk associated with price movements in the underlying asset by offsetting long and short positions. It is also referred to as short gamma or long gamma position in a synthetic hedging technique.
For example, a long call position must be delta hedged by shorting the underlying stock. This strategy is based on the change in premium i.e. change in the price of option caused by a change in the price of the underlying security. The change in premium for each basis-point change in price of the underlying is the delta and the relationship between the two movements is the hedge ratio.
In a Delta hedging process, it is mandatory to manage delta Greeks by maintaining delta as neutral. There are various methods to keep delta neutral with price change.

Let us take an example.
Say we have created a short gamma position of SBI.
Spot price is 300 INR.
We have bought one future
Two “At-the-money” call options @310/- are shorted at high Implied Volatility (IV). Here we want to get benefit of Vega.
We have shorted IV at a very high price. Once the panic settles, IV will go down and we will square off the position to book Vega profit.

Now let us understand how to manage this position, till the panic resolves.

(Note: option pricing is calculated using Black–Scholes model for Indian stock market.)

1.    Delta neutral by keeping 1% out manually 
Here we want to manage delta by keeping 1 % price movement out. i.e. in the above example if price moves up to 303, we will not calculate any delta. Once price goes to 303.5, we will calculate delta neutral at 300.5 and whatever quantity we get, we will buy that amount of equity. Thus we make 300.5 delta neutral. However, spot price is 303.5 at that time. So we call it 1% delta out. If price goes to 304, we buy equity for price 301 to make 301 spot price delta neutral.
Same way if price goes down to 297 from 300, we will not do anything. If it goes to 296.5, we will manage delta for spot price 299.5.

2.    Delta neutral by keeping 1% out by setting SL (stop loss)
This is similar to method 1. However instead of observing and doing it manually, we set a stop loss once we create a position. We sell equity at every half rupee change if price goes to or below 296.5 or buy equity at every half rupee change if price goes to or above 303.5.
In this method there is a risk of not being able to execute one or two stop losses if there are flashy movements in price. However, there are advantages. One can’t miss managing delta at all and one can manage the fear and greed which comes while using method 1.

3.    Delta neutral by keeping 1 % out with managing using a call –put option
This method is recommended only when gamma is comparatively high. In this method, if price goes to 303.5, we calculate a 0.3 or 0.4 delta put option and short it to adjust the delta neutral equity. Same way if price goes below 296.5, a 0.3 or 0.4 delta call option can be shorted.

4.    Delta neutral by changing strike
If the market goes in one direction i.e. if it continuously goes down, try to short “At-the – money” option and square off the current one. In our example, square off the 310 Call and short 300 call option.
If the market goes up, square off 310 call and short 320 call option.
Thus delta neutral will be managed automatically and you will remain mostly always on at-the-money option shorted.

5.    Run time Delta using equity with every price change
Every time price changes, manage delta. I.e. if spot price is less than 200, make delta neutral at every 0.5 paisa. If spot price is between 200-700, manage delta at every 1 rupee. Beyond that, manage delta neutral at every 2 rupees.
In this method, one can gain maximum benefit of the delta process. But the disadvantage is that it’s very difficult to manage positions of more than 3-4 scripts, if the market movements are very high.

Happy Option trading and position managing!