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 $1 decrease in the price of company XYZ’s shares will cause the price of the put option to increase by $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 $20 per share to $19 per share, the put option would be worth $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 $1 increase in the price of company XYZ’s shares will make the call option worth $0.50 more. Let’s say that company XYZ’s shares currently traded at £20 each. If the share price increased to $21 and the cost of the call option was $1, then the price of the call option will increase by $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.