What is Delta One Trading?
The financial world is full of jargon. One expression that pops up frequently is the expression “Delta One”. It sounds great, but what does it mean?
A Delta One product is a product that gives the investor the same exposure as if the investor were to own the underlying asset. This is as opposed to a non-delta one product like an option, which has an asymmetric payoff, causing price changes in the derivative to be different from the underlying asset.
For example, an investor would like to “own” the S&P500. The first alternative for the investor would be to buy all the 500 different shares that make up the S&P500, in the same proportions as the S&P500. If done correctly, the returns to the investor will now be the same as the return of the index. The investor has a Delta One position to the index – in this case by exactly replicating the index.
Now, buying each individual share of the S&P500 is somewhat tedious and perhaps not something an investor has the time or resources to do. So, instead, the investor can enter into a number of different contracts or trades that gives the same exposure. For example, the investor could buy shares in an ETF which tracks the S&P500. If the investor is a bigger player then they could buy futures on the S&P500 on an exchange, again, entering a Delta One trade (this one a derivative!). Or, if the investor has the infrastructure in place to do so, he could call an investment bank or a broker and ask to trade an Index Swap (another derivative). This index swap would be designed to give the same returns, as if the investor were to own the index – another delta one position!
All the above examples give the investor the exposure of the index, while outsourcing the actual replication of the S&P500 to another party. This will reduce the operational burden for the investor and allow index replication to be done by a specialist. These specialists, the delta one desks, will not only have better systems for replication than the usual investor, but might also have various advantages that allows them to replicate the underlying index more cheaply. For example, the delta one desk might have offsetting flows (i.e. a customer wanting to do the opposite trade) or engage in other activities that allow it to earn additional income (for example securities lending).
With the huge growth of index linked mutual funds, both traditional index-linked funds and exchange traded funds (ETFs), the delta one function in banks is a hugely important one. And, as more and more new and advanced indexes are launched, its importance keeps growing!