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An FX option position induces a risk, just as a spot or a forward position. A “delta neutral” management consists into fitting an option position with an FX Spot equivalent to compensate changes in risk induced by the option.
Example for a seller of a Call FX option: The risk on its position is to get exercised if the spot price at maturity exceeds the strike. In this case, the seller should buy FX Spot and sell it at strike price. This would be for him an even greater loss if the spot price is above the strike price. To get protected against this risk, the seller can apply a “delta neutral” management. It consists into taking a spot position opposite to the one induced by the option. Spot amount will be determined by the Delta: Nominal in base currency x Delta.
Example:
For a notional amount of USD 1M and a Delta of 0.7, the seller must buy USD 1M x 0.7 = USD 700,000. With this new spot position: if the EUR / USD increases by 1 cent, its optional position is losing 0.7 x 0.01 x 1M = 7,000 USD. But thanks to the delta neutral management, this loss will be offset by a potential gain on the long position in USD 700,000: 0.01 x 700,000 = USD 7,000. During the life of the option, the forward price of EUR / USD may rise. In that case, the value of Delta will increase as the option becomes potentially more exercisable. Imagine that the EUR / USD rate rises from 1.32 to 1.33, which indicates a Delta rising from 0.7 to 0.81. To offset the risk of its option position, the seller of the Call will increase its USD long position by buying an equivalent of 1 M x (0.81 – 0.7) = USD 110,000. Consequently, any induced loss on the optional position is symmetrically offset by a gain on the spot position. The introduction of the Delta in this calculation helps to take a spot position in full adequation with the optional position.
Conversely, if the price of the underlying is decreasing, the seller of a Call option will sell spot EUR / USD using the Delta.
For the buyer of a Call, the risk is limited to the premium. A delta neutral management can be implemented to protect against the risk of losing the premium amount. Symmetrically to the seller of a Call, if the underlying market is rising, the option’s buyer will take a short spot position (e.g. FX spot sell) to offset the risk associated with option. If the underlying market is down, it will increase its spot position.
More generally, we can see that market operators who are long or short option often use delta neutral management to cover induced respective risks. By taking positions on the markets of the underlying, they will amplify or dampen the movements instead.