For investors looking to hedge their stock portfolios against potential losses, delta hedging strategies offer a way to do just that. While there are a variety of different approaches that can be used, all seek to reduce the exposure of a portfolio to changes in the underlying security’s price. In this post, we’ll take a look at some of the most common delta hedging strategies.
For those not familiar with the term, “delta” is simply a measure of how much the price of an option changes about movements in the underlying security. So if you have a portfolio that is partially exposed to moves in a particular stock, using a delta hedging strategy can help reduce your risk and protect your profits. Let’s take a closer look at the most common delta hedging strategies that might be used by investors.
#1. A “Covered Call” Delta Hedging Strategy
The most commonly employed strategy is known as a covered call, which is basically selling a call option against a stock position you already own. For example, if I hold 1,000 shares of XYZ Company and am concerned that the price might fall, I could hedge my position by selling a call option on XYZ with a strike price of $40.
This technique works because when you write (or sell) an option in this way, you automatically buy to open what is known as a “replicating portfolio,” meaning there is no need to actually buy any additional options to hedge your position.
For example, let’s say that I own 1,000 shares of XYZ Company and sell 1 call option with a strike price of $40 for $.50 (with an expiration date set one month out). If the stock remains flat or rises above $40 before the option expires, I’ll simply let it expire worthless. But if the stock drops below $40, my option will be exercised and I’ll have to sell my shares at that price.
The beauty of covered calls is that you are automatically hedged when you initially create the position since your underlying position is “replicating” your sold call option.
#2. A “Collar” Delta Hedging Strategy
Another common hedging strategy is known as a collar. A collar is created by selling an out-of-the-money put at one strike price, while simultaneously buying an out-of-the-money call with a higher strike price in order to finance the put option. The idea here is that the cost of buying back your put should offset any losses from a decline in the underlying security’s price.
For example, let’s say I own 1,000 shares of Company XYZ and sell to open 1 out-of-the-money put at a strike price of $40 for $.50 (with an expiration date set one month out). At the same time, I’d also buy from open an out-of-the-money call at a strike price of $45 for $.50. This creates a collar position where I receive a net credit of $.01 to offset potential declines in the stock’s price.
This post should have provided you with an introduction to delta hedging and its strategies. We hope it also gave you some new ideas for how this strategy can be implemented in your investment portfolio. If so, we encourage you to continue researching the subject more deeply on your own or by consulting a financial advisor who specializes in these types of investments.