Hedgers use a variety of tools to help them measure risk. Some hedgers call those measurements the “Greeks.” Initially, the term “Greeks” came about because of the Greek letters used to label those measurements. These days, many hedgers include risk measures among the Greeks that don’t have Greek letters as labels. In this article and others, we will explore some of the Greeks and the ways hedgers use them to measure and ultimately manage risk. In this article, we will start with delta, one of the most commonly used Greeks.

Among hedgers, delta has various meanings that depend on context. These multiple meanings make it challenging to pin down a single, precise definition. Delta, however, is a foundational risk management concept, so it deserves the effort. In this article, we will explore the essential characteristics that almost all definitions of delta share. Future articles about delta will explore the various ways hedgers use the term “delta” and the contexts in which those uses make sense.

Starting at the beginning with the first letter will be useful. Think of the “d” in “delta” as the same as the “d” in “direction.” If you take one thing from this article, understand that delta is fundamentally a measure of directional risk exposure. Meaning, if you encounter delta in a risk management context and think, “Delta means direction.” - you will not be too far off most of the time.

If you followed the last paragraph, you are most of the way there for everything we will cover in this and future articles about delta. We should add a little more while that is still fresh. For delta to be a useful measurement of risk, one needs to calculate it in terms of something. In the same way that we can not measure distance without inches, feet, or miles, we can not measure directional risk without a unit. Just like measuring distance, the tool we choose depends on the context.

When measuring distance, sometimes it makes sense to use inches, sometimes it makes sense to use miles, and sometimes, it even makes sense to use the metric system. When measuring directional risk, it usually makes sense to use the most easily traded and liquid market as the unit of measurement. In the case of grain and soybean hedging, this usually means the most active futures contract for a given crop year. The most effective unit in other markets might be different.

So why does all of this matter? Suppose we want to create a market-neutral portfolio (a portfolio with as little directional risk as possible) or a portfolio with a specific amount of directional risk. In that case, we need a measurement to compare how we expect each of the portfolio’s components to perform. By converting each element’s directional risk into a standard unit, we can estimate the entire portfolio’s directional risk by totaling each part. If the total is undesirable, we can make a trade to bring the portfolio back to the desired level.

Managing the price risk in grain and soybean production involves many moving parts. The crop in the field, crop insurance, delivery contracts with the elevator, futures contracts, options contracts, and more contribute to the total directional risk. We can use delta and other Greeks to estimate how each part will perform, then evaluate how they will work together. That way, we can make informed decisions about whether we are taking the desired amount of risk. Trading strategies with a market-neutral focus, like our Quartzite Precision Marketing program for grain and soybean producers, make extensive use of delta and the other Greeks.

If you are sensing that we have just dipped a toe into profoundly deep water, you are right, and that is okay. If you have questions or feedback, we encourage you to contact us. Given enough time and effort, we believe anyone can learn to navigate these waters. Hopefully, these articles are a helpful step in that process. Of course, if you are short on time like most of us or feeling overwhelmed, we would be happy to discuss if we would be a good fit for your risk management needs.

Trader talk:

Another way traders occasionally use the term “delta” is for the percentage chance an event might happen. This usage has its roots in options trading and isn’t as common now as in the glory days of floor trading. Experienced options traders would offer this simple model to help younger traders understand delta in the trading world. Traders also used it in day-to-day communication about more mundane things. For example, if asked if he’d be at the bar for happy hour on Friday night, you might hear a trader say, “Yeah, there’s a ninety-delta that I’ll be there.” The trader meant he was ninety-percent sure he’d be there. We’ve included this usage because we will use it to explain delta in the specific context of options trading in a future article.