Option Symbol

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Option Symbol

• Understanding Options SymbolsOptions quotes
  follow a pattern that enables you to easily
  construct and interpret symbols once that formula
  is understood. The basic parts of an option
  symbol areRoot symbol Month code Strike
  price code

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Option Symbol

• A root symbol is not the same as the ticker
  symbol. Please refer to the option chain for that
  ticker to find the corresponding root.
• In conjunction with the option root symbol, you
  can utilize the tables below to assist you in
  creating or deciphering options symbols.
• Note Yahoo also requires the ".X" suffix to
  identify the security type as an option

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Expiration Month Code
4
Strike Price Code
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Strike Price Code
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Example

• For QQQ QQQDH
• For AOL AOLJK
• For IBM IBMDT
• For MSFT MSQDM

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Options vs Futures Hedging

• Both can be used to protect against adverse price
  movement.
• Option hedging allows price movements in favor of
  the cash position to be captured.
• But futures hedging prevents you from receiving
  the benefits of favorable price movements

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Importance of Basis in Option Hedging

• Basis is factor that remains important to hedgers
  even though they are using options rather than
  futures.
• Basis with options that are exercised is very
  easy to calculate.

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Selecting an Option

• For a hedger with options, the choices are many
• Usually at least seven to fifteen different
  strike prices and premiums are available.
• The hedger can select very cheap out-of-the money
  options to very expensive in-the-money options.
• Which should a hedger choose?

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Selecting an Option

• The decision will vary among hedgers and will
  change for a given hedger as conditions change,
• Several factors must be considered before
  selecting the options
• Two most important factors are
• Financial requirements
• Price Protections

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Selecting an Option

• Financial Requirements
• Option buying vs selling
• Price Protection When selecting an option, the
  hedger can choose various levels of price
  protections. Hedger may want to choose a price
  level that covers all costs and provide a profit
  margins or choose a price levels that covers only
  a portion of costs.

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Selecting an Option

• All costs plus a profit margin
• All costs
• Variable costs
• Fixed costs
• Cash costs
• Some percentage of costs

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Practical Hedging Considerations
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Types of Practical problems

• In this chapter, we will discuss about some
  practical problems that hedgers face.
• We have divided these problems into two sections.
• Cross hedging
• Selective hedging

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Cross Hedging

• The major problem in hedging any commodity is
  that the cash position and the futures position
  do not match exactly.
• Most of the times, futures contracts do not fit
  cash position of the hedger.
• This nonalignment can take several forms
• Different commodities The futures contract is
  for one commodity and cash position or need is
  for another similar commodity.
• Example Futures contract is sold for 2 yellow
  corn and the cash position is sorghum or alfalfa.

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Different forms of nonalignment

• Different grades/standards/maturities The
  futures is for only a specific grade or standard
  and/or maturity and the cash position is for
  another.
• Example Futures contract is specified as 2
  yellow corn and cash position is 3 corn

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Different forms of nonalignment

• Different time periods The cash position must be
  entered or liquidated on a time schedule other
  than the specified futures delivery periods.
• Example Cash position is expected to be
  liquidated on Feb 15 and the futures is for a
  March delivery period.
• Different Quantities The futures contract
  standardized size units do not match the cash
  position amount.
• Example Futures calls for 40,000 pounds of fed
  cattle and the cash position is 30,000 pounds.

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• Any one or combination of all four of these
  conditions will cause problems for the hedger.
• The first three of these considerations can be
  appropriately called cross hedging problems.
• Cross hedging simply the process of hedging when
  the cash position and the futures position do not
  match exactly.
• The fourth condition, one of difference in
  quantity, is also a cross hedging problem but is
  more correctly called the problem of over and
  under-hedging.
• The difference in quantity will also require a
  different calculation of net hedge price to
  reflect over- and under-hedging.

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Ways to handle these problems

• Different commodities The issue ranges from
  closely related and similar commodities to those
  that are seemingly unrelated.
• Is hedging possible for a rancher who has all
  heifers and the feeder cattle futures contract
  calls for steers?
• Hedging a cash alfalfa position with a corn
  futures
• Hedging 2 grain sorghum contract with a corn
  futures.

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Handling different commodities problem

• Although each of these products are closely
  related, they differ considerably in physical
  makeup and market structure.
• The real issue is not so much that the cash and
  futures commodities are closely related but that
  their price movements are closely related.
• The real issue in hedging and cross hedging is
  price movements and also the basis risk.
• To compare price movements, simple graphical
  analysis can provide useful analysis and also
  correlation analysis.

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Handling different commodities problem

• Hedging and cross hedging should only be
  attempted if the price movements are similar and
  basis risk is acceptable to the hedger.
• Do your homework before cross hedging.
• Study the historical relationship between the
  cash price and the proposed futures price to
  determine whether they are correlated.
• Check the correlation for the time period that
  the hedge will be placed.

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Problem of Different Grades/Standards/Maturities

• A cash position may be composed of 3 yellow corn
  and the future position is 2 yellow corn.
• The process is to study the historical price
  relationships between cash and futures prices to
  determine the degree of correlations.

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Problem of Different Time

• Hedges and cross hedges should, for beginning
  hedger at least, be placed using a futures
  contract month that expires as close to the
  actual final cash position as possible, but not
  before.
• If placed before the final cash transaction, then
  the hedge will have to be lifted before final
  transaction, thus the hedger is no longer hedged
  and the cash is in a speculative position.

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Problem of Different Time

• When the cash position is not known, then a
  process of hedging with the nearby, or one
  contract month away from the nearby, and then
  rolling the hedge is a common and accepted
  hedging practice.

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Problem of Different Quantity

• As indicated earlier, one of the most troublesome
  aspects of hedging is the issue of matching the
  size of the cash position and future position.
• Example Cash position may be 63,000 pounds of
  fed cattle but the live cattle futures is for
  40,000 pounds at CBOT and 20,000 pounds at Mid
  America Exchange.
• Can you hedge and if so, how much?
• Because of the inexact amounts of most cash
  positions, almost 100 percent of all hedges are
  either over-hedged or under-hedged.

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Problem of Different Quantity

• An over-hedged occurs when the futures quantity
  exceeds the cash quantity.
• An under-hedged occurs when the cash quantity
  exceeds the futures quantity.
• The problem can be handled by trying to match
  quantities as closely as possible.

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Problem of Different Quantity

• The easiest way to handle the problem of quantity
  is to use a combination of regular size futures
  and mini contracts to reach a futures position as
  close as possible to the cash position.

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Minimum Risk Hedge

• An alternative to trying to match quantities as
  close as possible is to consider a minimum risk
  hedge.
• A minimum risk hedge is a hedge that tries to
  equate dollar movement rather than quantity
  amount.
• The basic idea is that hedger wants price
  protection from hedging, not profit. True price
  protection occurs when the cash and futures move
  exactly the same and there is no basis change.

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Minimum Risk Hedge

• Therefore, some other process must be used to
  achieve dollar equivalency rather than matching
  quantities.
• One way to achieve this is to mismatch quantities
  based on historical information.

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Selective Hedging

• A naïve hedge is a hedge that is placed when a
  cash position is assumed and a hedge is
  maintained until the cash position is liquidated.
• Once you are comfortable with hedging, you may
  want to find ways to be hedged when the cash
  market prices are moving against you and not to
  be hedged when cash prices are moving in your
  favor.

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Selective Hedging

• Selective hedging has been shown to be effective
  in increasing net hedged prices.

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Selective Hedging

• To be effective, selective hedging must be used
  in conjunction with forecasting methods or
  trading strategies.
• There is an infinite numbers of trading
  strategies for selective hedging.
• The growth of personal computers during 80s and
  90s has increased the use of selective hedging.

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Some useful thoughts on hedging

• If you determine a proper hedge will yield a
  price objective and you are happy with the price,
  then dont change your plan when you see that you
  can get higher price by dropping the plan.
• The purpose of the plan is to minimize the greed
  factor of the hedge.
• Hedging is not something that should be done all
  the time.
• Consider each cash position separately and
  determine the risk of remaining unhedged and the
  risk of hedging and then make a decision
  concerning whether or not to hedge.

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Some useful thoughts on hedging

• If you are a novice
• Hedge on hypothetical account first.
• Act as if you are actually hedging and learn from
  the results.
• After numerous paper trades, then move to limited
  real hedging, perhaps with mini contracts and
  gradually develop a personal hedging program
  suited to your own individual needs.