Delta measures the total exposure you have to the market, or product you trade. If you have a one put option contract with a 0.50 delta, you are "short 50 deltas" or -50 delta. Likewise, if you own 100 futures contracts for corn, you have 100 deltas.
Consider an investor owning 100 futures contracts for corn and two put options of 0.50 delta. What is the delta? If you said 0, you are correct.
The goal is to reach a delta neutral state to eliminate directional bias. A delta neutral trading strategy involves the purchase of a theoretically underpriced option while taking an opposite position in the underlying futures contract.
This hedge requires one or more option contracts and therefore is only suitable for savvy investors.
The risks for this strategy are low, usually allowing one to hold a position without concern.
Trading cost can add-up as delta hedges are added and removed to maintain the delta neutral state.
To delta hedge a futures contract, you must first find an undervalued option. Consider 1360 December gold calls with the last traded price being $1960. The bid-ask is $2010 by $2050, and the theoretical price is $2503. This scenario tells you that the option is undervalued by $473.
Next, you need to determine how many underlying futures contracts to sell. The listed options delta will give you the answer. A call option will have a delta between 0 and 1.00. In this case, a 1360 call has a delta of .49 or just 49, which means that one 1260 call will be the equivalent of 49% of the underlying contract.
Options that are at-the-money will have a delta of around 50. In-the-money options will have a delta larger than 50. Out-of-the-money options will have a delta lower than 50. The underlying futures contract will always have a delta of 100.
To find the number of future contracts to short for delta neutral, divide 100 (delta of the underlying) by the options delta. In our scenario, we divide 100 / 49 and get close to a 2 to 1. So for every two gold call options purchased, you must sell one gold futures contract.
The goal is to for the combined deltas to be as close to zero as possible when added together. Once in the position, it is crucial to make adjustments to remain delta neutral. As the price of the position moves, so does the delta.
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.