A delta neutral portfolio is constructed by an option and the underlying instrument. The portfolio will, in theory, be immune against small changes in the underlying price. When talking about delta hedging, the hedge ratio of a derivative is used to define the amount of underlying price needed for each option. Delta hedging is the trading strategy that maintains a delta neutral portfolio for small changes in the underlying price.
Briefly, let's look at how to do this in practice. Suppose we have N derivatives. This needs to be hedged to protect against price movements. We then need to buy the underlying stock to create the hedge. The whole procedure can be described in three steps:
N derivatives need to be delta hedged
Buy underlying stock to protect derivatives
Rebalance hedge position on a regular basis
To determine how many stocks we need, we use the delta of the option, Δ. This tells us how much the option price changes for a change in price of the underlying...