Delta hedging
We have heard about a delta-neutral portfolio, which removed the risk of underlying price movement. Simply, it works like this. Suppose you own 1 BTC. You are positive about the long-term price of BTC going up, but not sure or even worried about the upcoming halving event.
So, decide to build a delta-neutral position for a while, so buy 20 put options with delta Yes, textbook approach! So perfect hedge lasts only for a short period of time or, within a very tiny amount of price change and would not work effectively in actual crypto trading where the index is in USD but priced and traded in BTC.
Thus, we would like to introduce our new delta definition. We will check relevant hedge effectiveness in terms of PnL, by constructing a delta-neutral portfolio with our BTC futures, which is based on the same underlying index and cheaper instrument compared to spot, also maturity-wise. However, to hedge perfectly, OKEx provides the Delta as So required number of futures contract for longing the 10 put option with BS delta Hedge is calculated like this:.
Under BS Delta hedging approach, 79 futures contracts are needed, so we constructed our portfolio with 10 Put and 79 futures. And futures PnL changed to 0. There should be a rounding issue, and because of option value non-linearity combined with BTC price and trade property made small debris, above PA Delta hedged PnL converged to 0.
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In addition, if simulate by yourself with other price movements, either up or down, our PA Delta idea is putting your portfolio in a perfect hedge at the transaction moment and protect your portfolio from any price swing, whether deep in or out. When the market goes down, you want the profits of your short position on the underlying to offset the long position on your call option.
Similarly, when the market goes up, you want the profits of your call option position to offset the loss in your underlying. While it may seem that both of these profits and loss should cancel each other, it's not always the case. Let's start with an example. Both are very liquid contracts, hence easily tradable. First we start by calculating the delta of the option.
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To do so, we need the following data points which can be found on the Internet or calculated by yourself. Historical Volatility of VIX for the past few days seems to be around I will use the value of Risk Free Rate - 7. Now that we have these values in hand, we can plug them into an option calculator to get the delta of the option.
Option Price has a good calculator that computes these values easily. Theoretical price is Just a note -- sometimes theoretical price may be well off the actual price. This all depends on what value you use for historical delta. Trading is an art as much as it is a science. Let's stick to the value of That means for every 1, shares we buy of the option, we need to sell shares of the underlying to be delta neutral.
Now that's a pretty table.
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However, before we get excited over this strategy, let's talk about risks involved in this strategy. Sadly, there is never such a thing as free money in trading. Every reward comes with its share of risk. If it stays put at the same place, then you fall at risk with the time value of the option.
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Let's say that today, we bought 1, shares of the Call Option and sold shares of the Future. If the price remained the same, then because of time value of the option, the price of the call option will go down. Delta Hedging is a great strategy for high returns, and low risk if you expect the market price to move.
You can use this strategy using a timeframe of a several days. Generally, intraday movement won't be enough to start making a profit.
But remember, you are somewhat market neutral with a delta hedging strategy. Delta hedging is applied on either call or put contract, not both. You would have to get the historical volatility as shown above and create the tables.