Delta Hedging and Gamma Scalping Explained
You are probably familiar with the term ‘hedge your bets’. When you hedge a position in the forex market, you are taking two opposing positions simultaneously. The idea is that one position gains when the other one falls, and vice versa. This limits your risk exposure when you do not know which way the market is going to go.
This concept gets a little more technical when we start talking about delta hedging and gamma scalping. If you have been searching for articles on delta hedging made easy, you will discover that is something of a contradiction in terms as it is quite a complex topic. There is nothing “easy” about it if you are not math-savvy. But in this article, we will attempt to explain delta hedging strategy and delta hedging vs. gamma scalping in as plain of terms as possible.
Delta Hedging Explained
In this delta hedging tutorial, we will talk about the basics, and do so in the simplest possible language.
First, let’s talk about how delta is defined. We can do this with a simple example. Imagine that you hold a particular asset, and you make $100 anytime the price of that asset increases by $1. This is a delta of +1.
Negative delta values are possible as well. If you are in a losing position, and you lose $100 anytime the price of an asset increases by $1, you have a delta of -1.
The goal of the delta hedging trading strategy is to attempt to maintain a position which is what we call, ‘delta neutral’—one which is neither negative nor positive, while capitalizing on changes in volatility for an asset. This process is referred to as ‘delta hedging volatility arbitrage.’ It is the difference between implied volatility and future realized volatility which provides the trader with an edge.
It is important to understand however that volatility changes can also expose you to risk—more on that later, when we talk about gamma hedging.
How to Use Delta Hedging
To understand how delta hedging currency options works, let’s take a look at a simple numerical example. Imagine that you purchase a 10,000-unit call option on GBP/JPY which has a stated delta of 50. You want a position that is delta neutral, which means you must now sell a spot on the same asset to balance out your delta. This spot is referred to as your ‘delta hedge’.
How do you determine the size of your hedge? The math is actually not all that complicated. Multiply 10,000 units by .50, and you will get 5,000 units. That means that your delta hedge needs to be equivalent to 5,000 units. Since you started out with a call option, you are going to need to sell 5,000 units on the spot market to get the correct hedge. At this point, you are delta neutral, which is what you want.
Now imagine that the delta underlying GBP/JPY changes. Let’s say it is no longer 50 but is now 40. If you were starting from square one with your hedge, you would have a different equation. It would be: multiply 10,000 units by .40, and you will get 4,000 units.
But you are not starting from square one. You currently hold two positions: the original 10,000 GBP/JPY call option, and the 5,000-unit short position on the spot market. You can see that your position is no longer delta neutral. It is out of balance. To get it back to delta neutral, you need to make an adjustment. You have to buy 1,000 units on the spot market. At that point, you will be back to delta neutral, as desired.
You do not necessarily need to start with a call option. You could choose a put option instead. Whether you are delta hedging a long call or a short-put option, the essentials are the same. The difference is that you need to balance a put option with a long position on the spot market rather than a short one.
Gamma Hedging Explained
Now, there is one more important concept to go over in conjunction with delta hedging to make money, and that is gamma hedging or gamma scalping. What are some great gamma hedging strategies, and why are they relevant?
Actually, these two concepts go hand in hand. In fact, you could say in the simplest terms that gamma is a measure of the rate of change of delta.
As a gamma hedging example¸ we can just continue with our discussion of the hypothetical hedge on GBP/JPY. You will recall that our delta changed from 50 to 40. If you missed that change, you would not adjust your holdings in time to keep your delta neutral.
The drop-in delta from 50 to 40 didn’t just happen in a snap, like an electron moving to a new valance level. It happened over some span of time across a specific number of pips.
With a gamma hedging formula, you are able to mathematically encapsulate that rate of change. You can then use this strategy to protect your portfolio from rapid changes in delta which might otherwise put you at risk.
When it comes to choosing between gamma scalping vs. delta hedging, delta hedging volatility on its own is less complex, but it does add to your risk. If you can take the time to learn about gamma hedging options, you can reduce that risk.
Which Forex Brokers Are Offering Delta Hedging?
To do this type of hedging, you will need to work with one or more forex brokers which allow you to execute call/put options and also participate in spot forex trading. Remember, you need to open two positions simultaneously to hedge, so you need to work with companies that allow you to do this. If all you have is a spot account, but you do not have an account which allows you to trade options, you will need to open one which does.
Some major trading sites which offer forex options trading include Nasdaq and Saxo among others. Indeed, Saxo actually shows the delta and gamma for a position right in the platform, as described here. Nasdaq provides this information as well, and even includes a detailed guide for getting started with options.