A trader purchased an out-of-the-money, E-mini S&P 500 call option. As you know, the underlying future for this option is the E-mini S&P 500 futures contract (ES).
The ES futures contract has a multiplier of $50. Whereas, the Micro E-mini futures contract (MES) has a $5 multiplier – making it 1/10 the size of ES.
The trader wants to hedge her delta exposure because the market has rallied since she purchased the call. She does not want to close out her long call position, but she does want to lock in some potential profit.
The option is now in-the-money with a 60 delta. For the one call option, this is a delta of .60, or 6/10, of one ES contract. To get delta neutral and lock in that profit she would need to sell 6/10 of the underlying futures contract, which is the E-mini S&P 500.
However, there is no way to sell a fractional ES futures contract.
Until now. With Micro E-mini S&P 500 futures, traders have access to a futures contract that is 1/10 the size and 1/10 the delta of ES. This means that 10 MES contracts give the trader the equivalent delta, or exposure, of one ES contract.
Our trader, who needed to sell a delta of 0.60 ES contracts can now do this by selling six MES futures.
Now that she is delta neutral and has protected her profit regardless of the market direction, her long call position with a 60 delta is offset by her short, six MES futures.
There you have it, precision delta hedging using the Micro E-mini S&P 500 futures contract.