What Is ‘Delta Hedging’ and How Can It Be Applied to a Liquidity Provider’s Position to Dynamically Manage Risk?

Delta hedging is a strategy that aims to reduce the directional risk of a position. The 'delta' of an LP position measures how its value changes relative to the price changes of the underlying assets.

To delta hedge, an LP would take an opposing position in a derivative, like a future or option, with an equivalent but opposite delta. As the asset prices change, the LP must continuously adjust the size of their hedge to maintain a 'delta neutral' state, which is complex and costly but can effectively isolate the fee-generating aspect of the LP position from market volatility.