Dynamic Delta Hedging

Dynamic Delta Hedging

Dynamic delta hedging is a term used for adjusting the delta of an option position due to price changes in the underlying security. One of the beauties and challenges of options trading is that there are so many different combinations to consider for any market outlook. Say you’re an income oriented investor and you have just established a delta neutral iron condor. In order to receive the maximum profit, you want the underlying security to stay between the two strikes and the entire position to expire worthless. As the stock or ETF begins to move your position will start taking on delta. The gamma of your position is the rate of change of the delta. If you were delta neutral when the position was initiated, check your gamma, the gamma is how much the delta will move with a one point move in the underlying. By knowing the gamma you can be prepared to make adjustments to your position to remain delta neutral. Complex positions that have a high positive theta will also have short gamma, meaning that you have to be prepared to adjust according to price movement in the underlying. In the case of a delta neutral iron condor, if the underlying makes an upward price move you have the choice of adding some long calls, more short puts or some long shares of the underlying stock. If it makes a downward move, you can add long puts, short calls or short some of the stock. Instead of just adding you can also look to reduce some contracts, so in the case of an upward move you’d want to buy back some of the short calls, or in the case of a downward move you could buy back some of the short puts, or you could consider any combination of the above.

One thing that you need to consider is how often you want to adjust, do want to check your position daily or several times during the trading day? Another consideration is how you choose to define delta neutral. Of course the strict definition is that delta neutral means zero deltas, however when it comes to trading you should establish a guideline so that you’ll allow some flexibility. It’s impossible to stay at exactly zero, so a good rule of thumb might be to say that you’ll allow a range of plus or minus 50 deltas. Allow the position to range from -50 deltas to +50 deltas and don’t make any adjustments until those levels are exceeded.

The final consideration is how to make the adjustments and that is where the fun comes in. Because there are so many different possibilities to evaluate for each position, it is wisest to use an expected return calculator and see which adjustments have the best mathematical expectancy. Remember if you want to add delta and want to add to the position you can buy stock, buy calls or sell puts. If you want to subtract delta and want to add to the position you can buy puts, sell calls or short stock. You can also adjust delta by closing out part of the existing position. Evaluating all of the possibilities is what makes options trading so flexible and challenging.



About sellacalloption

Author, Radio Show Host and Portfolio manager and chief option strategist for IWC Asset Management.

Posted on May 5, 2012, in Neutral Income Strategies, Option Basics and tagged , , , . Bookmark the permalink. Leave a comment.

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