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National Hog Farmer is the source for hog production, management and market news
January 30, 2017
Today, many hog 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 varies 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 zero 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% would rise in value by about $0.25, while a put option on that same futures contract with a delta of -50% 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 CME Lean Hog futures are trading at $78 per hundredweight. If you want to protect that hog price, and leave open the possibility of participating in further price gains, you could purchase a put option with a strike price of $78. A put option gives you the right, but not the obligation to sell hogs at the strike price. Because the strike price of the put is the current market price, this option will have a delta of -50%. If hog futures then rise to $88, or by $10, the value of your option might lose most, if not all, of its value, but you will be able to sell your hogs on the cash market for $88. What happens if hog futures decline instead by the same $10? The value of your put option will rise by $5, and you have the right to sell hogs at $78.
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 $78 price floor), you could sell a call option at a strike price of $88. 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 hog 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 hog producer will manage margins by addressing not only revenues, but also feed costs. With grain prices potentially moving higher due to strong demand and the possibility of lower acreage this coming spring, 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. Given that current projected margins do not exactly compare favorably with historical levels, you may want to preserve the opportunity to participate in higher prices if the market continues moving up. 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 hog prices, as described in the previous example. Those positions are illustrated in Table 1.
Since the strategies for feed and hogs 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 hog 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 that hog prices may rise, as well as the operation’s desire to hopefully achieve stronger forward profit margins.
Protection in stronger margin environments
We can also imagine a very different margin environment, where prices are relatively high and margins are very strong. For example, let’s say hogs are trading at $88 per hundredweight 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 hogs, or revenue, side of the equation.
You could protect the historically attractive hog price by selling a futures contract. The delta on that position would be -100%. If however, you still believe there is some opportunity for hog 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 an $88 put option and simultaneously sell a $98 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 Table 2.
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 like that in Table 2. 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, call CIH at 866-299-9333. There is a risk of loss in futures trading. Past performance is not indicative of future results.
Vice President, Education and Research, Commodity & Ingredient Hedging LLC.
Chip Whalen is vice president of Education and Research at CIH. Chip plays a critical role in the development of CIH’s educational programs, and lectures extensively both in their Chicago training center and around the country. With more than 15 years of teaching experience, he has broad knowledge of the commodities industry, and is the author of numerous articles frequently contributing to industry publications including National Hog Farmer. Chip is also the editor of CIH’s popular email newsletter, Margin Watch, a free publication which objectively analyzes forward profit margins of various agricultural industries including swine. He has been with the company since its inception, and has extensive experience assisting clients in the management of commodity price risk. Chip literally grew up in and around the Chicago Board of Trade, the son of a grain trader who was a member of the exchange. He holds a Bachelor’s of Business Administration from Loyola University, Chicago.
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