Let’s assume that you currently hold 100 shares in company XYZ. You decide to hedge yourself against any adverse price movements in the underlying market by taking out a call option with a delta of -0.50.
So, a CHF 1 decrease in the price of company XYZ’s shares will cause the price of the put option to increase by CHF 0.50. This is because the price of a put option’s delta moves inversely to the price of the underlying asset. As a result, if the price of company XYZ decreased from CHF 20 per share to CHF 19 per share, the put option would be worth CHF 0.50 more per share – partially offsetting the loss to your shareholdings.
If, on the other hand, you had a short position on company XYZ, you could use call options to hedge your position. If you held a call option with a delta of 0.50 on company XYZ stock, then a CHF 1 increase in the price of company XYZ’s shares will make the call option worth CHF 0.50 more. Let’s say that company XYZ’s shares currently traded at £20 each. If the share price increased to CHF 21 and the cost of the call option was CHF 1, then the price of the call option will increase by CHF 0.50 per share.
To fully hedge their position, a trader would attempt to reach a delta-neutral state, where the option’s price movements are perfectly balanced in relation to the price movements of the underlying asset. To achieve a delta-neutral trade, an individual would take multiple positions until the delta effectively mirrored the price movements of the underlying.
However, delta-neutral trading strategies are only advised for advanced traders due to the constant monitoring required to make the strategy effective.