Delta neutral hedging strategy

on Aug 23, 2012 in Derivative, Home | 1,287 comments

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The option price does not always move in conjunction with the price of the underlying asset. Consequently, it is important to understand the factors contributing to the price movement of an option, and the effects they generate.

Delta for instance measures the sensitivity of an option’s value to a change in the price of the underlying asset. It indicates how much the value of an option should change when the price of the underlying share rises by 1 USD.

For example, if you short one call, maturity December 12 with a delta of -0.45, you should lose USD 0.45 if the share price goes up by 1 USD.

Now, if you want to create a market neutral position, you should sell enough calls so that the net position is delta neutral.  The term means that your position has no market directional bias, in other words the position is neutral to market movement.  

In a covered short call strategy, you are buying the underlying shares and shorting call options against it. For instance, if you are long 100 shares SPY, you could sell 2 contracts with a delta of 0.5 at the money calls, or 4 contracts with a delta of 0.25 out of the money calls and so on. If the net position delta is at or close to zero, your position will not have directional risk as long as it remains delta neutral.

The primary motivations for this strategy is that you are prepared to liquidate the share at a defined price above current market value and cost price, and sell the option to pocket a decent premium.

Once you go short on the call, you are exposed to the risk of having to sell shares at the strike price when the share price is trading upwards. If the stock price moves downwards, the call options decrease in price. You can either buy back the call option to close your position, or, you could wait, hoping that the options expire worthless.

Some investors believe this option strategy is worth your consideration as you will be able to sell the share for a fair price and generate a premium income from the option.