Hedge Ratio
A hedge ratio is the overly complicated term for a rather simple idea.
Essentially, the hedge ratio refers to the delta of an option. Delta is the amount by which the underlying option will change in price for small changes in the stock price. Remember, an option with a delta of 0.50 means the option will move $0.50 for every $1.00 move in the stock.
A trader uses a hedge ratio in order to buy (or sell) the correct number of options to effectively hedge a stock position. The exact formula for the hedge ratio is explained by the Black-Scholes option pricing model.
Here’s a simple explanation…
If a trader buys 100 shares of ABC stock and an underlying ABC put option is trading with a 0.50 delta, the trader would need to buy 2 put options to have a neutral market position. As you can see, in this example the hedge ratio is 1:2. In other words, the trader is buying 1 unit of stock and buying 2 units of put protection in order to be market neutral in the entire position.
Remember, since each underlying option contract correlates to 100 shares of stock, the trader has to buy 2 puts with a delta of 0.50 to neutralize a long position of 100 shares.
The hedge ratio can be adjusted according to how much risk the trader wants to take at any given moment. By selecting options with a lower delta, 0.30 for example, the stock position will be open to more downside risk if prices fall. On the other hand, if the price of ABC stock rises, the entire position will make more money.
Of course, there are many variations of hedging a stock position. It all depends on the risk/reward profile the trader is looking for.
Category: Options Trading Basics
