Why You Should Get to Know Delta

Today, many agriculture operations find they need the flexibility of exchange-traded options, which allow you not only to protect attractive margins, but also capture future incremental improvements. If you’ve avoided options due to their complexity or cost (or both), an understanding of delta can help you overcome these hurdles so you can gain the pricing flexibility you need.

Delta Reflects Protection
Put simply, delta is the sensitivity of an option’s value to a futures price change. If an option position is held until expiration, it either essentially becomes a futures contract or it expires worthless. But until then, option positions have value – expressed as a premium – that vary over time and in response to changes in the underlying commodity futures contract. For each option position, or combination of option positions, we can measure the extent to which its value will change when the futures price of the underlying commodity changes. That is the position’s delta.

Just as the premium of an option is an objective reflection of its value, delta is an indicator of the amount of protection afforded by each option position. Together, premium and delta allow you to calibrate the precise cost/protection balance of an option position.

Calibrate Your Delta to Match your Needs
Delta is measured as a percentage from 0 to 100, and can be positive or negative, depending on the direction of the change in value. If a futures contract rises by $1, a call option on that contract with a delta of 25 percent would rise in value by about $0.25, while a put option on that same futures contract with a delta of -50 percent would decrease in value by about $0.50. The higher the absolute delta, the stronger the hedge and the higher the degree of protection the position will provide to an adverse change in price.

For example, let’s say Class III milk futures are trading at $17 per hundredweight (cwt) and corn is at $4 per bushel. If you want to protect that milk price, and leave open the possibility of participating in further price gains, you could purchase a put option with a strike price of $17. A put option gives you the right, but not the obligation to sell milk at the strike price. Because the strike price of the put is the current market price, this option will have a delta of -50 percent. If milk futures then rise to $19, or by $2, the value of your option might lose most, if not all, of its value, but you will be able to sell your milk on the cash market for $19. What happens if milk futures decline instead by the same $2? The value of your put option will rise by $1, and you have the right to sell milk at $17.

If the cost of that protection seems too high, you could consider adding a second piece to your hedging strategy. In addition to buying the put option (establishing a $17 price floor), you could sell a call option at a strike price of $19. This position establishes an obligation to sell, but at a price that is above the current market. The combined position has a lower total cost since the premium you collected from selling the call would offset some of the cost of the put. It also has a higher delta (closer to -75%) than the put option alone, and thus will provide more protection against declining milk prices. The tradeoff, however, from that higher delta is less opportunity to participate in higher prices.

Manage Both Sides of the Margin Equation
A savvy livestock or dairy producer will manage margins by addressing not only revenues, but also feed costs. With grain prices hovering near historical lows, it might make sense to simply book feed ingredients in the cash market with a local supplier. On the output side, however, there’s more room for both gains and losses. Even if your current projected margin compares favorably with historical levels, you may want to preserve the opportunity to participate in higher prices if the market continues moving up. And it’s always a good idea to protect your operation against the risk of significant declines.

You can accomplish this dual goal by purchasing a put option against output prices, as described in the milk example. Those positions are illustrated in the below table.

Feed Short Buy forward 100% 0%
Output Long Buy put -50% 50%

Since the strategies for feed and output are different, they carry different net exposures and deltas. The grain is already priced in the cash market and there are no corresponding exchange positions, thus the delta (protection) of the feed position is effectively 100% and the net exposure is 0%. We know the delta on the output position is neutral, -50%, providing a balance between protection against price declines and an equal opportunity to participate in gains. The net exposure of 50% is consistent with an expectation for increased prices for output, such as milk, hogs or cattle.

Protection in Stronger Margin Environments
But we can also imagine a very different margin environment, where prices are relatively high and margins are very strong. For example, let’s say milk is trading at $19 per cwt and feed ingredients are already secured in the cash market. In this case, you might have a more negative bias, expecting prices to decline over time. For that reason, it would make sense to have a stronger delta on the milk, or output, side of the equation.

You could protect the historically attractive milk price by selling a futures contract. The delta on that position would be -100 percent. If however, you still believe there is some opportunity for milk prices to rise and you would like to participate in further price increases, you may choose a strategy with a strong delta. Let’s assume you buy a $19 put option and simultaneously sell a $21 call option. This strategy will likely have a delta of around -75%, meaning that you are protecting 75% of risk from lower prices while allowing for 25% opportunity to participate in higher prices. In this case, your overall hedge profile would look like the below table.

Feed Short Buy forward 100% 0%
Output Long Buy put
Sell call
-75% 25%

These examples are simplified in that they show a static delta. In fact, both delta and premiums will fluctuate over time as the futures market changes. This is true for both a single option position as well as a multi-option position. As prices change, margins will also vary. You may find that over time, as prices and margins fluctuate, you wish to maintain a different degree of protection, and thus a different delta. That’s why you may wish to adjust a hedge position – and your delta – to maintain the cost/protection balance that’s right for your operation.

If you have questions or would like more information, please call CIH at 1.866.299.9333.

Futures and options trading involves the risk of loss. Past performance is not indicative of future results.