Delta hedging is a practice mainly used by market makers in the options market. What happens is that when the market maker sells puts, they then short shares of the stock as a hedge against the put they just sold. They don’t typically sell in a one to one ratio. For instance, if the market maker sells 100 puts of XYZ Corp., this represents 10,000 shares of stock since each option represents 100 shares. But since the options they sold are out of the money rather than selling 10,000 shares of the stock, they sell 5,000 shares as a hedge against the puts. The market maker may use the “delta” to calculate how many shares they need to sell to be properly hedged.
If XYZ stock starts falling, the market maker has to sell more shares to be properly hedged as the puts are rising in value. Once the stock drops below the strike price, the delta hedging kicks in even greater. On an option’s expiration Friday like this past Friday, things can spin out of control in a very rapid fashion.
A delta hedging collapse isn’t something that happens all that frequently, but when they happen they are vicious moves to the downside. If played properly, they can be quite profitable.
Inspired by his high school economics teacher, Rick Pendergraft fell in love with the markets at an early age. He entered his first investing competition at 17, and opened his first brokerage account before he finished college. At the age of 23, on the third options trade he had ever placed, Rick turned $1,800 into $22,000 in less than a week, when the company he bought became the target of a takeover. He admits it was a stroke of luck, but it was a memorable education as to the leverage that options can provide.
After a ten year career in banking, Rick decided to pursue trading full-time. To get his foot in the door, he started out in the sales department at Schaeffer’s Investment Research. It was not long before his talent was recognized and he was invited to apprentice under Bernie Schaeffer, one of the top options traders in the world. Rick thrived in his new position and twice received the award for “Top Trader.”
Rick has developed a loyal following of readers who are grateful for his timely warnings and profitable advice. He is widely recognized as a market expert and has been frequently quoted by Reuters, BusinessWeek, Forbes, USA Today, the New York Times, and the Washington Post. Rick’s primary focus is on identifying short and intermediate term rising and falling trends in the major market sectors. His analysis is based on technical factors along with indicators of market sentiment
Rick is currently the Editor-in-Chief of The Velocity Strategy. He lives near Delray Beach, FL with his wife and three children.
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