InvestorQ : What is the actual use of delta? It looks too complicated for me to use in my daily trading in options?
indhumathi Sayani made post

What is the actual use of delta? It looks too complicated for me to use in my daily trading in options?

user profile image
shrinidhi Rajan answered.
2 years ago

It is one thing to understand the concept of delta but what is more important is to understand the practical application of Delta. How do options traders use the concept of delta to take practical decisions? It needs to be understood that an At-The-Money (ATM) option will always have a delta of around 0.50. Therefore an Out-of-the-money (OTM) option will have a delta lower than 0.50.

Let us understand this with an example of how Delta can be used for hedging your risk more scientifically and precisely. Assume that a trade is expecting the Nifty to go up and has bought 5 lots of Nifty 10,000 Call Options at a premium or Rs.55. Since the spot Nifty is currently quoting at Rs.9920, the above call option will be an OTM call option. Hence the entire premium will be in the nature of time value only. As we have seen earlier, an OTM option will typically have a delta of less than 0.50. For the sake of simplicity let us assume that the delta of this particular call options is 0.40.

A day after the trade was initiated, the US Fed announced a hike in rates and the trader was sceptical that if the markets move down further he may lose the entire premium on his options. He therefore decided to delta hedge his options potions position. He can hedge his position by selling delta equivalent number of futures lots. Now Futures will always have a delta of 1 as the futures tends to move in proportion to the spot price. So, the 5 lots of call options can be hedged by selling 2 lots (5 lots of options X Delta of 0.4) of Nifty Futures. The table below captures how the delta hedged position will look like…

Options Position

Futures Position for Delta Hedge

Long on OTM 10,000 Call – 5 Lots

Short on Nifty Futures – 2 Lots

Total Delta of the Option – 0.40

Total delta of the Futures (- 1)

Total Delta Exposure (5X0.4) = 2 Deltas

Total Delta Exposure (2 X -1) = -2 Deltas

In the above case, the Delta Hedge gives a perfect hedge as the net delta in the above case is Zero. Thus the trader is now completely immune to any movement in pricing. This is one of the most important applications of Delta.