Introduction

In the world of options trading, managing risk is paramount. Delta hedging is a fundamental strategy used to mitigate risk by maintaining a balanced position. In this chapter, we explore the dynamic aspects of delta hedging and differentiate between dynamic hedging and the more passive “hedge-and-forget” approach. Understanding these dynamics is crucial for successful options trading.

Dynamic Aspects of Delta Hedging

Delta, as we’ve learned, measures the sensitivity of an option’s price to changes in the underlying asset’s price. In delta hedging, traders continuously adjust their positions to maintain a neutral delta. This means that as the underlying asset’s price changes, traders buy or sell more of the underlying asset or its derivatives to offset the changing delta.

• Example: Let’s say you hold a call option with a delta of 0.60, indicating that for every USD 1 increase in the underlying asset’s price, the option’s price increases by USD 0.60. If the asset’s price rises by USD 1, you would need to sell 0.60 units of the asset to maintain a neutral delta.

Benefits of Dynamic Delta Hedging:

• Risk Reduction: Dynamic delta hedging helps traders reduce directional risk. By adjusting the position as the underlying asset moves, traders can ensure that their exposure to price changes is minimized.

• Profit Opportunities: Traders can capitalize on short-term price movements. For example, if the asset’s price rises, they may sell some of it at a higher price.

• Adaptability: Dynamic hedging allows traders to adapt quickly to changing market conditions, maintaining a balanced position.

Hedge-and-Forget Strategies

On the other hand, some traders adopt a more passive approach, often referred to as “hedge-and-forget”. In this strategy, traders establish a position and do not make adjustments as the market moves.

• Example: If you buy a call option and simply hold it until expiration without making any adjustments, you are employing a hedge-and-forget strategy.

Comparison: Dynamic Vs Hedge-and-Forget Strategies

• Dynamic Hedging: Requires continuous monitoring and adjustment. It’s proactive and aims to maintain a balanced position. Offers flexibility but demands active management.

• Hedge-and-Forget: Involves less active management. The trader accepts the initial risk and potential rewards without continuous adjustments. Simpler but may expose the trader to more significant risks if the market moves unfavorably.