What is Delta Hedging?

• Delta is a risk metric that estimates the change in price of a derivative given a $1 change in its underlying security; it basically estimates how much the price of an option taken to hedge the position changes when the position itself changes by $1.
• Hedging is a strategy that aims to reduce risk in a financial asset by taking a position that moves in the opposite direction as your current position.
• If you have a long position (you expect prices to go up), you take a put option to hedge it. If you have a short position (you expect prices to go down), you take a call option to hedge.
• Delta is positive for call options (0 to 1) and negative for put options (-0 to -1). Call options are meant to increase in value when the price moves $1 while puts are expected to increase in value when the same security moves down $1.
• The investor tries to reach a delta neutral state; that is a state where he does not lose anything if the trade moves in the direction opposite to his position.

<aside> 💡 For example, assume I take a long position on a stock X by buying it. I then buy a put option of the stock X to hedge my risk. If the delta of the put option is -0.8, then when the underlying stock decreases in value by $1, the put option increases in value by $0.8, all else being equal.

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<aside> 💡 In terms of crypto trading, delta hedging can be achieved through crypto options. In terms of de-fi, it can be achieved with the help of third party protocols (as most major ones such as Uniswap or Aave do not allow it on their own).

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How do you make money from delta neutral strategies?

A delta neutral position can make money from change in implied volatility, change in underlying price, and/or time decay (if short options).

• Eg: buy 500 shares of ABC at $49.75 and ten $50 puts, each with a delta of -50 so you're delta neutral.
• ABC immediately drops to $48.75 with no change in IV. The put delta is now -590 (each put has a delta of -59). You now buy 90 shares at $48.75 to restore delta neutral.
• ABC immediately recovers the $1 back to $49.75 so you sell the 90 shares, restoring delta neutral and booking a $90 gain.
• The more times that XYZ moves up and down or down and up, the more opportunities that you have to do this. In order to make a profit, before expiration you must book gains faster than the rate of time decay.

Note: The example given above is in case of traditional finance. Explaining some of these terms in brief

• Implied volatility means the volatility of the underlying security which is used to price the option.
• Time Decay refers to change in price of an option as it nears its expiration.