Delta Hedging - Overview, How It Works, Pros and Cons

When it comes to investing, delta hedging is one of the strategies that stock investors should be familiar with. Delta hedging is a method used to protect an investment from price movement. It works by using options contracts to offset any changes in the underlying security's price. While delta hedging does have some pros, there are also cons to consider before implementing this strategy. Let's take a closer look at what delta hedging is and how it works. Then we'll discuss the pros and cons so you can decide if this strategy is right for you.

What Is Delta Hedging?

Delta is a measurement of how an option's price changes about the underlying security's price. A delta of 0.50 would indicate that if the underlying stock rose $1, then typically an option contract will rise by half a dollar (or 50 cents). Conversely, this relationship works in reverse as well; if the stock falls by a dollar, then the option will be expected to lose 50 cents.

How Does Delta Hedge Work?

Now that we understand delta basics, let's take a closer look at how this strategy works in terms of hedging. For example, if you own shares of Google and want to protect your investment from a price decline, you could purchase Google put options with a delta of 0.50. This means that if the stock price falls $1 due to any number of factors, then you will make half as much as the decrease in the underlying security (in this case it would be a loss of 50 cents).

Pros and Cons: The Pros and Cons of Delta Hedging As with any investment strategy, there are pros and cons to consider before implementing delta hedging. Let's look at both now:

Pros of Delta Hedging Prevents Losses - the main purpose of delta hedging is to protect an investment from price movement. By purchasing put options that have a delta of 0.50, the underlying stock must fall by one dollar before the option will lose 50 cents. This prevents big losses from occurring, which is a common reason many investors turn to delta hedging.

Proven Strategy - according to the CBOE, 90% of professional options traders use this strategy to protect their investments from price movement Cons of Delta Hedging Costs Money - as you can imagine, delta hedging costs money. To successfully implement this strategy, an investor must purchase put options with a delta of 0.50, which will cost money.

Time-Consuming - to make sure the protection is in place and effective, investors need to continuously check on prices and adjust accordingly - this process may be more time-consuming than expected. If the stock price doesn't fall, then an investor is out of pocket for the cost of the put options that will expire without being used.

Tax Implications - With any Delta hedging strategy, whether it's delta hedging or another type of investment protection, there are tax implications to keep in mind. A loss on a hedge is typically a capital loss, which is subject to taxation. On the other hand, if you have managed to secure again from delta hedging, it is likely considered as a lower-tier long-term capital gain with a tax rate of 15%.