What is delta hedging and how does it work in cryptocurrency?

If you are new to long-term trading and investing, you will most likely come across a situation where a catalyst causes huge volatility in your portfolio. While this may be acceptable for risk-tolerant people investing in growth-oriented assets, investors are often advised to use hedging to reduce the risk in their crypto portfolio. This is where hedging and delta hedging come in.

Curious to know how hedging works and how advanced investors take delta hedging to the next level? Learn how fund owners limit their risk and leverage derivatives with our beginner's guide to delta hedging in crypto portfolios.

Main conclusions

• Delta hedging is used to manage risk by buying or writing option contracts to reach a delta neutral position.
• There are three types of option contracts that you can use in delta hedging: in-the-money options, in-the-money options, and out-of-the-money options.
• Despite the benefits of delta hedging, it also comes with risks associated with constantly changing positions. We advise delta hedging only for those who are well versed in option trading and the mechanics of pricing their premiums.

What is delta hedging?

Delta hedging is an advanced risk management strategy that allows investors and traders to offset the risk of a price decline with option contracts. This often involves buying or writing option contracts to bring the position or portfolio to a delta-neutral state.

Before diving headlong into the world of delta hedging for crypto portfolios, it is necessary to first understand the mechanics of hedging and then discuss the use of derivatives to implement such a risk management strategy.

To the uninformed, hedging strategies are like taking out an insurance policy for your car in a traffic accident-prone area. While you cannot completely avoid the possibility of being involved in a traffic accident if there is an inherent risk of driving in the area, you can mitigate the potential impact with a hedging risk management strategy. While risk reduction costs a fraction of your gains, it is definitely worth the price if volatility causes you to lose a huge portion of your portfolio.

Although hedging involves the use of any financial instrument, investors often resort to the use of derivatives because of the clear relationship between the portfolio asset and the contract from which it stems. When using derivatives such as option contracts, delta hedging comes into play. From delta-neutral positions to hedging an underlying position, here's everything you need to know when it comes to learning the mechanics of delta hedging your portfolio in-depth.

How does delta hedging work?

If you're new to options trading, you should check out our complete guide to options trading before embarking on an options learning journey. For starters, delta is one of the four option Greeks and a useful risk metric that estimates the change in the price of an option contract when the underlying asset changes by $1 or a basis point. This means that for every $1 the asset rises, the price of the option increases by the amount of delta.

At the same time, it is important to understand how the delta works for underlying assets and their derivatives. Call options have a positive delta ranging from 0 to 1, with call options having a delta of 0,5 at expiration. Conversely, put options have a negative delta that ranges from -1 to 0, with a put delta at exercise of -0,5. Meanwhile, underlying assets such as stocks and cryptocurrencies have a delta of 1.

Now that we understand the basics of delta, let's move on to delta hedging a cryptocurrency portfolio with calls and puts. In the next section, we will divide options into three different categories and provide specific examples of delta hedging so you know how you can delta hedge your cryptocurrency portfolio appropriately.

In-the-Money

In-the-money options refer to derivative contracts that have both intrinsic and extrinsic value. When exercised, these contracts have strike prices that are favorable compared to the current market price of the asset. This means that when the option expires, traders holding the contract will be able to either buy the asset at a lower price or sell it at a higher price, depending on whether the option contract is a call or a put. More on this will be discussed below.

Call Options

In-the-money call options are bought by traders because they believe that the market price of the asset is currently undervalued and will exceed the option's current strike price upon expiration. For example, if the current market price of ETH is $1, buying an in-the-money call option means buying a call option with an exercise price of $770 or less. When the call option expires, you will be able to buy 1 ETH at a discount of $700 or more since the contract has expired in the money.

Let's say you already have a short position of 3 ETH. To hedge this position, you can consider a contract in the money, for example, an option 1500c ETH 28042023, which has a delta of 0,81. To delta hedge your position, you need to buy 3 of these ETH calls. This is to ensure that the negative delta of the short ETH position is partially offset by the call you just bought. Specifically, your delta will decrease to 0,57, or about 81%.

Put options

Conversely, traders tend to buy put options because they believe that the market price of the asset will be lower than the strike price of the put contract at expiration. For example, if the current market price of ETH is $1, buying an in-the-money put means buying a put with an exercise price of $770 or higher. When the put option expires, you will be able to sell 1 ETH for a premium of $800 or more since the contract expired in the money.

As the price of ETH continues to fall, the premium for these puts will rise as they become more profitable. The reverse is also true, as puts tend to become less valuable if the price of ETH goes up.

Let’s say you have already bought an ETH put and want to delta hedge your ETH put contract. First you need to determine its delta. For reference, we will use the 2000p ETH 28042023 contract, which has a delta of -0,67. To properly delta hedge this position, you need to place a long order of 0,67 ETH.

At-The-Money

As mentioned earlier, the delta of calls and puts at the time of execution is 0,5 and -0,5, respectively. Using the example of ETH options contracts, buying a call or a put at the time of exercise means buying contracts with an exercise price of $1. You will notice that although both contracts have deltas not exactly 800 and -0,5, they are still numerically equal to 0,5.

To create a delta hedging strategy, simply short 0,52 ETH if you have a long call or buy 0,48 ETH if you have a long put.

Out Of The Money

Out-of-the-money options refer to derivative contracts that have only intrinsic value. If at expiration the current market price of the asset is not higher than the strike price of the call option or lower than the strike price of the put option, then the option loses its value. This ultimately makes the price of these option contracts dependent on the time to expiration.

From the perspective of the Greeks of options, this is where theta comes into play, each day of which contributes to the collapse of the option. Understanding theta decay aside, here's how you can delta hedge your positions when trading out-of-the-money option contracts.

Call Options

The upside to trying to delta hedge out-of-the-money calls is that you will need less capital to offset the directional risk of these option contracts. This is mainly due to their low delta value, which makes their option premiums change less when the price of the underlying asset changes by a dollar. In this case of out-of-cash ETH calls, let's consider hedging the 2000c ETH 28042023 contract. With a delta of 0,33, you would need to short 0,33 ETH to delta hedge your position.

Put options

Similarly, due to the low delta value, delta hedging out-of-the-money put options requires less capital investment. To delta hedge the 28042023p ETH 1500 contract, you would need to buy 0,18 ETH to balance your positions.

How to trade delta neutral

If you have looked at our previous examples, you will understand that they are a mixture of a partial delta hedge - where the percentage of directional risk is reduced - and a full delta hedge, where the net delta is zero. For portfolios with zero delta, delta neutrality is achieved. By carefully balancing positive and negative deltas, traders can end up with a delta-neutral position that accounts for potential upcoming catalysts and short-term risks.

Benefits of delta hedging your crypto portfolio

The most important aspect of delta hedging your portfolio is that it can be profitable for you if you hedge strategically. Considering the aforementioned theta decay and the reduction in implied volatility as the major catalyst passes, option premiums tend to fall over time. This can work in your favor if you use options hedging as a short-term way to reduce volatility.

The second benefit of delta hedging is that it allows you to protect your portfolio from downside risk without having to close or reduce your positions. In the end, market timing wins over market timing – so trying to constantly get in and out of positions can be costly in the long run, as your portfolio can suffer from emotional buying and selling.

Risks of Delta Hedging Your Crypto Portfolio

However, delta hedging also has some disadvantages. While it can be beneficial for your portfolio, delta hedging can be costly due to constant repositioning. This can lead to costly transaction fees and wasted time as you balance deltas and make sure the portfolio is delta neutral at the same time.

Another underestimated risk of delta hedging is that hedging is ultimately subjective, which can lead to overhedging. This is a situation where traders proactively overshoot their downside risk and spend the excess to hedge their portfolio. The result is a huge delta hedge that eats up profits without taking into account the risk of direction.

Is it profitable to delta hedge your crypto portfolio?

There is much debate when it comes to the profitability of delta portfolio hedging. As discussed earlier, delta hedging can be beneficial for your cryptocurrency portfolio, but for it to be profitable, you need to make informed decisions and know the mechanics of options. Ultimately, the decision to delta hedge a cryptocurrency portfolio comes down to your personal preference and whether the potential gains and volatility protection are worth the time and effort.

Сonclusion

In general, delta hedging should be considered if you are well versed in options trading and the mechanics of pricing their premiums. While delta hedging is considered by some to be a big waste of time, for riskier investors and traders it acts as an actively managed insurance policy. Because it requires constant vigilance and up-to-date information about the markets, delta hedging is certainly not for the faint of heart. However, if you ignore its subtleties, you will find an extremely useful risk mitigation strategy that protects your portfolio from depreciation without the risk of reversing existing positions.