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Delta hedging
By Martin | October 19, 2011
Delta is the neutral hedge ratio derived from the Black-Scholes model the ratio of underlying asset to options necessary to create the risk-free portfolio that is at the heart of the Black-Scholes option pricing formula.
So the delta of a stock option indicates the number of shares needed to hedge a position in an option on that stock.
For example a portfolio long 100 stock call options with delta of 0.3 is delta hedged by a short position of 30 shares and the delta of an interest rate option indicates the notional amount of interest rate swap required to hedge it against small movements in interest rates.
Delta hedging is the application of this concept to the hedging of options portfolios.
A true delta hedge is the combination of underlying asset and money market instrument that creates the riskless hedge Black-Scholes says will exactly replicate the pay-off of the option to be hedged.
See delta, dynamic hedging, static replication, replication.
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