Some traders use options to speculate on the price movement of an underlying asset; other traders use options to speculate on changes in the volatility, implied or realized, of that asset. Put a little differently: while no options trader can afford to ignore the role that volatility plays in the price of a contract, not all options traders are interested exclusively or even primarily in volatility. If you’re essentially a stock picker who likes to lever up by buying puts and calls, know that many options traders are doing something different from that.
Recall that there are three components that affect the value of an option: price, time, and implied volatility.* Changes in the price of the underlying asset will affect the price of an option on that asset, as will the passage of time and changes in expectations of future volatility. We measure the exposure an option contract has to those three components and report them as the greek variables delta, theta, and vega. (Vega is not a Greek letter, but it is a greek letter.)
Now, if you’re an options trader of the second type – i.e., not just a stock-picker on steroids – and you have a view to express about volatility, then you’ll want to reduce your exposure to other irrelevant variables. It’s like running a business: if you know you’re good at selling insurance, and if you’ve become one of the biggest and the best insurance companies around, then if you’re smart you’ll think twice before risking your entire company on your ability to make sausages (or to sell OTC credit derivatives, which isn’t so different: you put a lot of nasty stuff in a sack and hope not to hear from your buyers anytime soon).
That’s why options traders and authors in academic finance journals spend so much time thinking about delta hedging. It’s not really an optional line of inquiry, if you’ll pardon the pun: hedging away unwanted risks is a key survival tactic. Traders who have a consistently profitable thesis about (or skill at trading) volatility will only be profitable overall if they can reduce or eliminate the impact of variables other than volatility. Delta hedging of some form or another is a necessary but not sufficient condition for successful options trading.
In the followup to this post, we’ll look at some popular methods for hedging away delta risk.
* Of course, interest rates and other carrying costs matter, too, but not nearly as much, and not enough to warrant discussion in this post.