To understand how a commercial bank dealer hedges a derivative exposure, four key terms must be identified and explained. These terms are at the center of risk control reports that should be clearly reported by trading systems to management.

The terms are Delta, Gamma, Theta and Vega.

Delta: The Delta is the dollar change in the option price relative to the dollar change in the underlying security. Those of you with a calculus background will know this as the first derivative. Values of Delta are between 0 and 1.

Going back to the example of IBM call options, the March 105 call with the stock trading at 100 will have a higher delta than the 110 call because it is closer to realizing its value. Using the example with a put option, a 100 put would have a greater delta than the 95 put.

Traders will often use the terms in the money, out of the money when discussing delta. Generally the following can be stated.

If delta < .30 then it is out of the money

If delta = .50 then it is at the money

If delta > .70 then it is in the money

The first form of hedging is known as delta hedging.