Hedging with wheat futures and options

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Hedging with wheatfutures and options

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Why Futures and Options Work
Futures Price
Convergence
Time
Cash Price
Delivery
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How Futures and Options Work

• Futures as a temporary substitute for cash
  --producers/suppliers can sell futures before
  actual cash sale to establish price
  --end users can buy futures
  before actual cash purchase to establish price
• Options as price insurance
  -- premium can be paid to insure
  against an adverse price move

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Futures and Options Comparison
ADVANTAGES Hedging in Futures Buying
Options Writing options 1.Reduces price risk
1.Reduces price risk 1.Generates
income 2.Offers marketing 2.Offers marketing
from premium flexibility flexibility
received 3.Known cost risk 2.Offers
marketing limited to premium
flexibility 4.Maintains profit potential
5.No margin account needed no
margin calls 6.No further
action required, but may be offset or
exercised if advantageous

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Futures and Options Comparison
DISADVANTAGES Hedging in Futures Buying
Options Writing options 1.Margin
account 1.Must pay premium 1.Margin account
needed subject to up front needed subject
to margin calls 2.Premium may be margin
calls 2.Must perform on lost if option
expires 2.May be required to contract or offset
worthless perform if option is 3.Profit
potential exercised limited as is loss
3.Risk unlimited if potential price
moves adversely 4.Profit limited
to premium no potential for further
gains from option position
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The Short Hedge - In A Declining Market

• 
  Futures Cash
• Transaction Transaction
• April 15
• Sell futures 3.48 -
• July 15
• Sell cash wheat - 3.29
• Buy back futures 3.29 -
• Futures profit/
• Cash received .19 3.29
• Total Return .19 3.29 3.48

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The Short Hedge - In An Advancing Market

• Futures
  Cash
• Transaction Transaction
• April 15
• Sell futures 3.48 -
• July 15
• Sell cash wheat - 3.60
• Buy back futures 3.60 -
• Futures loss/
• Cash received -.12 3.60
• Total Return -.12 3.60 3.48

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Futures Profit/Loss from Proceeds from
Net Price Net withoutPrice
Futures Position Cash Sale
Received Futures Hedge4.00 -.52
4.00 3.48 4.003.75 -.27
3.75 3.48 3.753.48 .00
3.48 3.48 3.483.25 .23
3.25 3.48 3.253.00 .48
3.00 3.48 3.00
Producer Hedging At Various Price Levels
As the table indicates, the net price received is
a constant 3.48. The short hedge protects a
selling price against a declining market, but
precludes gains if the market advances. With the
short hedge, additional returns are relinquished
to protect an acceptable selling price. Note
These examples do not account for basis or
commission fees. Hedge results will be affected
by changes in the basis, or the difference
between the futures price and the cash price at a
specific location.
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The Long Hedge - In An Advancing Market

• Cash
  Futures
• Transaction Transaction
• January 22
• Buy futures - 3.60
• April 15
• Buy cash wheat
• (futures price less .20 basis) 3.65 -
• Sell Futures - 3.85
• Futures profit/ Cash paid 3.65 .25
• Net Price paid 3.65 -.25 3.40

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The Long Hedge - In A Declining Market

• Cash Futures
• Transaction Transaction
• January 22
• Buy futures - 3.60
• April 15
• Buy cash wheat
• (futures price less .20 basis) 3.18 -
• Sell Futures - 3.38
• Futures loss/ Cash paid 3.18 -.22
• Net Price paid 3.18 .22 3.40

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Futures Cash Price Paid - Profit/Loss from
Net Price Net withoutPrice
(Futures-Basis) - Futures Hedge
Paid Futures Hedge4.10
3.90 (.50)
3.40 3.903.90 3.70 (.30)
3.40 3.703.60 3.40 (.00)
3.40 3.403.40 3.20 (-.20)
3.40 3.203.25 3.05 (-.35)
3.40 3.05
Elevator Hedging At Various Price Levels
As the table indicates, the net price paid is a
constant 3.40. The long hedge protects a buying
price against an advancing market, but precludes
a lower price if the market declines. With the
long hedge, additional gains from lower prices
are relinquished to protect an acceptable buying
price. Note These examples do not account for
commission fees and assume a constant basis of 20
cents under the futures price. Hedge results
will be affected by changes in the basis.

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The Producer Options Example 1
Option's Futures Premium Intrinsic
Value Net Price Net Price Cost(bu.)
(Strike-Futures) Received w/o
Option 3.50 -.10 .00 3.40 3.50 3.40 -
.10 .00 3.30 3.40 3.30 -.10
.00 3.20 3.30 3.20 -.10 .10
3.20 3.20 3.10 -.10 .20
3.20 3.10 3.00 -.10 .30
3.20 3.00 2.90 -.10 .40
3.20 2.90 Note that the minimum price
received with options is equal to the strike
price selected less the premium paid
(3.30-.103.20). The producer who bought the
put has locked in a minimum price of 3.20, but
has not eliminated his potential to gain if
prices increase. The producer who does not buy
the put saves the premium cost if prices
increase, but has no downside protection. (This
example does not account for basis or commission
fees.)
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The Producer Options Example 2
Option's

Futures Forward Contract
Premium Intrinsic Value Net Price Net Price
Price Price Received -Cost(bu.)
(Futures-Strike) Received w/o Option 3.80
3.30 - .06 .40
3.64 3.30 3.70 3.30 - .06
.30 3.54 3.30 3.60 3.30
- .06 .20 3.44 3.30 3.50 3.30
- .06 .10 3.34 3.30 3.40 3.30
- .06 .00 3.24 3.30 3.30
3.30 - .06 .00
3.24 3.30 3.20 3.30 - .06
.00 3.24 3.30 3.10 3.30
- .06 .00 3.24 3.30 Note the
minimum price with options is equal to the
forward contract price less the premium paid
(3.30-.063.24). The producer who bought the
call has locked in a minimum price of 3.24, but
has not eliminated his potential to gain if
prices increase. The producer who does not buy
the call saves the premium cost, but has
eliminated his potential to gain if prices
increase. (This example does not account for
basis or commission fees.)
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The Country Elevator Options Example
Option's Futures Premium Intrinsic
Value Net Price Net Price Price Cost(bu.)
-(Futures-Strike) Paid w/o Option 3.60 .20
-.40 3.40 3.60 3.50 .20 -.30
3.40 3.50 3.40 .20 -.20
3.40 3.40 3.20 .20 -.00
3.40 3.20 3.10 .20 -.00
3.30 3.10 2.90 .20 -.00 3.10 2.90
Note that the maximum price with options is
equal to the strike price selected plus the
premium paid (3.20.203.40). The merchandiser
who bought the call has locked in a maximum
buying price of 3.40, but has not eliminated his
potential to benefit from price declines. The
merchandiser who does not buy the call saves the
premium cost if prices decline, but has no upside
protection. (This example does not account for
basis or commission fees.)
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The Baker Options Example
Option's Net Futures Premium
Intrinsic Value Inventory Net
Value Price -Cost(bu.) (Strike-Futures)
Value w/o Option 3.60 -.10 .00
3.50 3.60 3.50 -.10 .00
3.40 3.50 3.40 -.10 .00
3.30 3.40 3.30 -.10 .10
3.30 3.30 3.20 -.10 .10
3.30 3.20 3.10 -.10 .10
3.30 3.10 3.00 -.10 .10
3.30 3.00 Note that the
minimum value with options is equal to the strike
price selected less the premium paid
(3.40-.103.30). The baker who bought the put
has locked in a minimum inventory value of 3.30,
but has not eliminated his potential for profit
if prices move up. The baker who does not buy
the put saves the premium cost if prices
increase, but has no downside protection. (This
example does not account for basis or commission
fees.)
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The Miller Options Example
Option's Futures Premium Intrinsic
Value Net Price Net Price Price Cost(bu.)
-(Futures-Strike) Basis Paid w/o
Option 3.70 .19 -.50 .30
3.69 4.00 3.60 .19 -.40 .30
3.69 3.90 3.50 .19 -.30 .30
3.69 3.80 3.40 .19 -.20 .30
3.69 3.70 3.30 .19 -.10 .30
3.69 3.60 3.20 .19 -.00 .30
3.69 3.50 3.10 .19 -.00 .30
3.59 3.40 3.00 .19 -.00 .30
3.49 3.30 2.90 .19 -.00 .30
3.39 3.20 Note that the maximum price paid
with options is equal to the strike price
selected plus the premium paid, plus the basis
(3.20.19.303.69). The miller who bought the
call has locked in a maximum buying price of
3.69, but has not eliminated his potential to
gain if prices decline. The miller who does not
buy the call saves the premium cost if prices
decline, but has no upside protection. (This
example does not account for commission fees.)
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Individual Considerations

• Basis correlation with futures market
• Size of operation
• Production risks
• Storage availability
• Personal risk tolerance level

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Stress-Testing

• What if? scenarios
• Worst case scenarios
• Range of possible outcomes

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Kansas City Board of Trade