4 Basic Hedges

Published: June 2, 2022
Robinhood has introduced many retail investors to options trading. Options are attractive because they have the potential for large gains using little capital. Some critics of Robinhood compare it to a casino, selling what are essentially lottery tickets while gamifying the experience and hiding the risk.
With value investing the goal is to invest rather than gamble. However the options market has a large effect on the supply and demand of of a stock because of delta hedging.
This hedging activity produces buy and sell pressure that can affect the price of a stock, sometimes dramatically. A good example is the GME short squeeze by retail investors.
In order to effectively invest, it's beneficial to understand how delta hedging works and how it influences a stock's price.

Delta Hedging

When individuals buy options someone must sell the option. When they sell options, someone must buy the option. There is a constant demand for buying and selling options and market makers and dealers act to fulfill this demand.
Like a store, they sell what buyers want and buy what sellers sell. However, they are in the business of making money on fees from facilitating transactions. They do not care about the intrinsic value of their inventory. They aim to maximize volume and fees from trading activity and to do this will buy and sell anything even if the owners personally feel that some of the items are overpriced junk.
As long as there is a willing counterparty, they will trade anything. TSLA call options, Berkshire Hathaway shares, SPY, bitcoin, rocks, potatoes, it doesn't matter as long as it moves with volume.
As long as there is a willing counterparty, they will trade anything. TSLA call options, Berkshire Hathaway shares, SPY, bitcoin, rocks, potatoes, it doesn't matter as long as it moves with volume.
To do this they have to remain delta neutral. This means that the total value of their inventory remains the same no matter how the market moves. If one portion of their inventory goes down in value, then another portion should go up and vice versa. Maintaining this balance of inventory is a constant balancing act and is done via 4 basic hedges.

1. Hedging a Long Call

When a trader buys a call option, he or she is buying the right but not the obligation to buy a stock at a a strike price. The dealer who takes the other side then takes on the responsibility to sell the stock at the strike price if the buyer exercises the option.
To hedge this, the dealer will buy the stock at the same time as they sell the call option. This way, if the buyer exercises the option, the dealer can sell the stock to them.The dealer is simultaneously long the stock by buying it but also short the stock because it has sold a call option on it.
An example. Let's says TSLA is at $790 and someone wants to buy a call option at this price. The price of the call option is 45.20 with a delta of 0.5.
The dealer would sell the option for $4520 and take a transaction fee. The buyer would be exposed to 50 delta while the dealer would be exposed to -50 delta.
To get to delta neutral, the dealer has to buy 50 shares (which have a delta of 1 each) so that the total delta is 0. This would cost the dealer 50 * 790 = $39,500.
The option buyer has not actually bought the stock, but by buying a call option has indirectly has caused $39,500 of buy pressure using only $4520.
Note that the dealer now has two pieces of inventory, 50 shares of TSLA and a sold call worth $4520. These roughly balance out according to Black-Scholes. Remember that the dealer here is trying to make money on trading fees. The $4520 from the option sale is intended to balance with holding the underlying TSLA stock and is not profit.
As the stock price changes across time, the delta of option also changes so the dealer must constantly buy and sell to re-hedge and maintain delta neutrality. This can create even more complex effects that are beyond the scope of this article.
However the key takeaway is how buying a call option affects the other actors in the market. A large amount of investors buying call options as lottery tickets on a company selling the future would create a lot of buying that would push the price upwards despite the option buyers not having bought any stock themselves.
The dealers are also happy to buy the stock even if they don't believe in company because they are delta hedged.
This is how speculation can create buying activity that sends a stock to the moon even if no one wants to actually own and be long the underlying stock.

2. Hedging a Short Call

When investors sells a call option (e.g. with a covered call ) they are acting similar to the dealer in the example above. However individual investors may not want to maintain delta neutrality since unlike dealers or market makers they don't get paid for helping to facilitate transactions.
One reason an investor may sell a call is because it feels like an extra bit of income. If I am holding 100 shares of TSLA, I may as well sell a covered call on it to make some extra money.
While there are philosophical reason why this actually isn't income, for argument's sake we'll assume that there are still many investors who treat it as so.
(To summarize the link, risky assets have value because they have moon potential. To sell a covered call as income creates a limit to that potential which makes holding the risky position less valuable. The income from the covered call isn't "free" but is stolen from potential future returns)
When a dealer buy a call from an investor, they end up owning the call option. To remain delta neutral, they must sell stock. Let's run through an example using the same numbers from above.
Let's says TSLA is at $790 and someone buys a call option at this price. The price of the call option is 45.20 with a delta of 0.5.
Using these numbers, when a dealer buys a call option they pay $4520 in exchange for a delta of +50 since they now own the call option. To achieve delta neutrality they must then short 50 shares of TSLA creating $39,500 worth of sell pressure.
Just like before, the total assets in the dealer's inventory balance out according to the Black-Scholes model and they only make money on trading fees.
The key takeaway is that when traders sell calls to dealers or market makers, they indirectly cause sell pressure.

3. Hedging a Long Put

When buying a put, the buyer is buying "insurance" while the dealer is selling it. The buyer is exposed to negative delta and benefits if the stock price goes down so the seller is exposed to positive delta.
In order for a dealer to reach delta neutrality they must then short a corresponding amount of stock.
The key takeaway is that when many investors are looking for insurance because they believe that a stock is overpriced then there will be corresponding sell pressure on the stock.The lack of faith expressed by the put buyers manifests itself as downwards price pressure.

4. Hedging a Short Put

When a trader sells a put, the opposite of the above happens. The dealer buys the put and is delta negative while the trader is delta positive. To be delta neutral, the dealer has to buy stock.
A trader may do this because they want to make money by selling insurance to an overly fearful market. Or they may be willing to buy a stock at a lower entry point and wants to make money by selling puts to make money while waiting for that entry point.
The effect of hedging activity that comes from this is very low as "selling insurance" is not a typical retail investor activity. Unlike buying calls (lottery tickets), selling calls (extra income), and buying puts (panic insurance) which are more affected by greed and fear.

Summary

In theory options trading shouldn't affect the market. However a lot of options activity takes place with dealers and market makers facilitating these trades. As these entities rely on delta neutrality for their business models, their hedging and re-hedging efforts can create interesting and volatile effects.
The 4 basic hedges that market makers use to maintain delta neutrality are:
  1. When dealers sell a call, they must buy stock to be delta neutral.
  2. When dealers buy a call, they must short stock to be delta neutral.
  3. When dealers sell a put, they must short stock to be delta neutral.
  4. When dealers buy a put, they must buy stock to be delta neutral.
For popular meme stocks with a lot of retail activity this can be rephrased as:
  1. When retail buys calls, they indirectly create upwards price pressure.
  2. When retail sells calls, they indirectly create downwards price pressure.
  3. When retail buys puts, they indirectly create downwards price pressure.
  4. When retail sells puts, they indirectly create upwards price pressure.
In practice, retail buys calls a lot more than the other 3. This flurry of call option activity combined with market maker hedging can create price bubbles that are supported only by continuous activity.
One of the benefits of value investing is that they are almost by definition overlooked and underappreciated and so are usually not affected by the madness of crowds.