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Delta hedging is a method of ensuring that the value of a stock portfolio or option will not fluctuate when the price of the underlying stock changes. This can be accomplished by buying or selling the underlying stock or by buying and selling related options. Hedging should be done with caution, as frequent hedging can lead to the owner earning less profit on the investment.
A stock portfolio is a collection of investments held by an investor or group of investors. Owning a varied portfolio reduces the overall risk of the investment. Portfolios usually include stocks and options.
An option is a contract between two parties. The seller of the option agrees that if certain events happen in the market, the seller will give the buyer of the option the choice to buy or sell certain stocks. The buyer of the option can choose not to buy or sell the stock, but the seller must give the buyer first option and abide by the buyer's choice.
The delta of a portfolio is the rate by which the value of the portfolio will change if the value of the underlying stock undergoes small changes. In mathematical equations, this amount is written as the Greek character delta, which looks like a triangle. Though the delta of a portfolio is a number between 1.0 and -1.0, it is usually calculated as a percentage of the total number of shares in the option. Stock brokers and private owners use delta hedging to make the delta of a portfolio equal to zero. This is called a neutral portfolio.
Delta hedging can be accomplished using a direct method or an indirect method. In the direct method, the broker or owner may buy or sell some of the underlying stock to offset the delta. When using the indirect method, the broker buys or sells options related to the stock. This method of delta hedging is best used when the underlying stock is difficult to trade. The delta then becomes the sum of the deltas of all the bought options.
Delta hedging can be a valuable tool to remove unwanted risk from an investment. However, it should be used cautiously. The greater the risk involved in an investment, the greater the possible profit. If an owner hedges too often, he or she can remove too much of the risk, leading to little or no profit from the investment.
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