Hedge Fund, Hedging and Position Delta

Upon having a conversation with my brother, Varun, about hedging, I thought it might be a great idea to share what exactly is hedging and a hedge fund. He does not have a background in finance and I thought it would be interesting to talk about it here so that anyone, finance background or not, can learn about hedging and maybe give me some tips, suggestions and comments on my knowledge of hedging.

A hedge fund works in a similar manner as a mutual fund where there is a fund manager who invests money he receives from the investors. However, there is a difference between a hedge fund and a mutual fund, a big difference. A hedge fund is not limited to just stocks like its counterpart mutual funds. A hedge can invest in almost anything but it is mostly derivatives. Even though a hedge fund maybe a good portfolio diversifying activity, it is VERY risky. A lot of research prior to investment is a must.

AND, Hedging is when you have a position in an asset and you take a position in a derivative  to offset the exposure.

But, what exactly is that position to offset the exposure? What exactly is a position delta?

Delta is a measure of risk in the options trading market. It basically tells us how many contracts should be in place to  hedge  a long or a short position of an underlying asset.

Before I give an example, here is some vital information:

Values of delta: In the Money (when the strike price is below market price for a call option and vice-versa for a put): 0.8

Out of the Money (when the strike is higher than market price for a call option and vice-versa for a put): 0.3

At the Money  ( when the strike price equals market price for the underlying asset)                                  : 0.5

Note: The above values were provided to me by my Professor, Professor Joseph Rinaldi, who also happens to be my boss, and these values may vary depending on the source such as an out of the money delta could be 0.25 instead of 0.3. I have seen that happen but I am going to go with what my professor told me).

Also, another vital piece of information:

Long Call: Delta Positive

Long Put: Delta Negative

Short Call: Delta Negative

Short Put: Delta Positive

Now, an example to explain the above concepts. Let’s say the strike price of the underlying asset is 45 and there are 10 short put contracts with an out of the money delta of 0.3, what could be some strategies to offset the exposure?

One of the strategies could be to short 300 shares (10 contracts = 1000 shares and 1000*-0.3 = 300 shares). Some other strategies could include holding a long position in an out of the money put or short out of the money calls.

Since, there is a slim chance of an out of the money option to go in the money (Delta of 0.3 = 30% probability to go in the money), what happens if it does go in the money? Well then to obtain an in the money position to offset the exposure the following could be done:

  • Sell 500 more shares (10 contracts = 1000 shares and 1000*-0.8 = 800 shares, but we already sold 300 shares, so now we take the difference so that we do not over expose ourselves)
  • Short In the money call
  • Long in the money put

I hope the above information helped explaining the concept of hedging a little bit. Comments are highly appreciated.

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