Delta-Neutral Stability

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What is delta-neutral stability?

Delta neutrality is the concept where your position on net has zero delta. Delta (Δ) measures the sensitivity of the price of an option to changes in the price of the underlying asset. It represents the rate of change of the option's price with respect to a one-unit change in the price of the underlying asset.

This means the portfolio is NOT exposed to the price change in the underlying value of the asset.

To expand on the earlier example:

Injera initially has a positive delta of 1 ETH because a user has provided 1 ETH as backing. This means that if the price of ETH increases, the value of Injera 's holdings also increases, and if the price decreases, the value decreases as well.

To hedge against this positive delta and achieve delta neutrality, Injera decides to go short on a perpetual contract. Going short means betting that the price of an asset will decrease. By shorting a perpetual contract with a position size equal to 1 ETH, Injera effectively offsets the positive delta created by the 1 ETH backing.

As a result of this hedging strategy, the overall delta of Injera's portfolio becomes 0. This means that regardless of whether the price of ETH goes up or down, the value of Injera's portfolio will remain relatively stable because any gains or losses from the ETH holdings are balanced out by the gains or losses from the short position in the perpetual contract.

In simpler terms, Injera has balanced out the risk associated with changes in the price of ETH by taking an opposite position in a perpetual contract, ensuring that the overall portfolio is not significantly affected by fluctuations in the price of ETH.

An important consideration is that Injera trades with no effective leverage across exchanges as the delta offsetting short perpetual positions are equal in size to the backing assets.

To note, many institutional market makers remain delta-neutral to avoid profits/losses from price volatility and this is a very familiar concept across both traditional finance & digital assets.