Hedging and Options Examples

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Hedging and Options Examples

• Prepared by Paul Dietmann, Sauk County
  UW-Extension Agricultural Agent
• Advanced Marketing Strategies Class
• January 7, 2004

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Hedge Taking a position in the futures market
that is equal and opposite to the position a
person expects to take in the cash market. It is
essentially a temporary substitute for a
transaction that will occur in the cash market at
a later date. As long as the cash price and
futures price move at the same rate, any loss in
one market will be offset by a gain in the other.
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On June 20, 2003 a Sauk County cash grain farmer
decided to hedge 5,000 bushels of corn that he
intends to deliver in October to Rock
Springs. June 20 Sold 1 contract of Dec, 2003
corn for 2.40/bu. (He knows that the basis at
harvest is typically -.25 at Rock Springs so he
expects to get 2.15/bushel cash) October 15
Bought 1 contract of Dec. 2003 for 2.16/bu. Sold
5,000 bushels at Rock Springs for
1.91/bu. Result Made .24 on the futures
transaction Lost .24 in the cash market Net
price was 2.15/bushel
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On August 19, a Sauk County dairy producer
started getting nervous about rapidly rising
soybean meal prices and decided to hedge his
winter protein needs. August 19 Bought 1 Dec.
2003 soybean meal contract (100 tons) for
178.10/ton (He knows that the local basis for
soybean meal is typically 5/ton so he expects
to pay 183.10 cash) November 3 Sold 1 Dec.
soybean meal contract for 255.50/ton Bought 100
tons of soybean meal for 260.50/ton, cash
price Result - Made 77.40/ton on the futures
contract Lost 77.40/ton in the cash
market Net price was 183.10/ton
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On August 19, a Sauk County soybean grower thinks
that the soybean price cant go much higher so he
decides to hedge some of crop for fall
delivery. August 19 Sold 1 Nov bean contract
for 5.40/bushel (He knows that the local basis
at harvest is -.40 so expects to receive 5.00
cash) November 6 Bought 1 November bean
contract for 7.57 Sold cash beans for
7.17. Result- Lost 2.17.bu on the futures
contract Made 2.17 in the cash market Net
was 5.00.bushel
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On August 22, a Sauk County beef producer decides
to hedge a load of cattle that he intends to sell
in November. August 22- Sells 1 Dec live cattle
contract for 80.17/cwt. (He knows the local
basis for cattle in November is typically -3/cwt
so expects to receive 77.17/cwt) November 24
Buys 1 Dec live cattle contract for
96.27/cwt Sells a load of cattle for 93.27/cwt
cash Result - Lost 16.10/cwt on the futures
contract Made 16.10/cwt in the cash
market Net price was 77.17/cwt
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On August 1, a Sauk County dairy producer decides
to hedge some of his November milk
production. August 1 Sells 1 Nov BFP contract
(200,000 lbs) for 12.94/cwt (He knows that his
basis is typically 1.00/cwt so expects to
receive 13.94) November 14 Buys 1 Nov BFP
contract for 13.40/cwt His November base milk
price ends up being 14.40/cwt. Result - Lost
.46/cwt on the futures contract Made .46/cwt
on the cash price Net was 13.94/cwt.
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Your turn! On July 1 a Sauk County corn grower
wants to hedge 5,000 bushels for delivery in late
October. The Dec corn futures price on July 1 is
2.25. The local basis in October is typically
-.25. What price would he expect to receive at
delivery? He delivers the corn on October 21,
the Dec futures price that day is 2.15, and
basis is the same as expected. What are the
results of the hedge?
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Your turn! On July 1 a Sauk County corn grower
wants to hedge 5,000 bushels for delivery in late
October. The Dec corn futures price on July 1 is
2.25. The local basis in October is typically
-.25. What price would he expect to receive at
delivery? 2.25 (futures) minus .25 (basis)
2.00/bushel He delivers the corn on October 21,
the Dec futures price that day is 2.15, and
basis is the same as expected. What happened
Oct. 21 and what are the results of the
hedge? Bought 1 Dec corn contract, made
.10/bu Sold cash corn for 1.90/bu, lost
.10/bu Net price was 2.00/bu.
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A twist on the scenario! On July 1 a Sauk County
corn grower wants to hedge 5,000 bushels for
delivery in late October. The Dec corn futures
price on July 1 is 2.25. The local basis in
October is typically -.25. What price would he
expect to receive at delivery? 2.25 (futures)
minus .25 (basis) 2.00/bushel He delivers the
corn on October 21, the Dec futures price that
day is 2.15, but the basis WIDENED to
-.35/bushel. What happened Oct. 21 and what
are the results of the hedge?
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A twist on the scenario! On July 1 a Sauk County
corn grower wants to hedge 5,000 bushels for
delivery in late October. The Dec corn futures
price on July 1 is 2.25. The local basis in
October is typically -.25. What price would he
expect to receive at delivery? 2.25 (futures)
minus .25 (basis) 2.00/bushel He delivers the
corn on October 21, the Dec futures price that
day is 2.15, but the basis WIDENED to
-.35/bushel. What happened Oct. 21 and what
are the results of the hedge? Bought 1 Dec corn
contract, made .10/bu Sold cash corn for
1.80/bu, lost .20/bu Net price was 1.90/bu.
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Options
Options grants the right, but not the
obligation,to buy or sell a futures contract at
a predetermined price for a specified period of
time.
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Options Terminology
Strike Price The price at which the futures
contract can be bought or sold. Premium The
cost of the right to buy or sell a futures
contract the cost of the option. The buyer
loses the premium regardless of whether the
option is used or not.
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Put Options, Call Options

• PUT OPTION
• Gives buyer right to sell underlying futures
  contract.
• CALL OPTION
• Gives buyer right to buy underlying futures
  contract.
• In both cases the underlying commodity is a
  futures contract, not the physical commodity

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Options Premiums

• Options premiums are determined by two factors
• INTRINSIC VALUE The difference between the
  strike price of the option and the price of the
  underlying commodity futures contract. If the
  strike price for a put option is lower than the
  price of the underlying futures contract, the
  intrinsic value is zero.
• TIME VALUE The amount allocated to the risk of
  a price swing between the day the option is
  purchased and the day it expires.
• INTRINSIC VALUE TIME VALUE PREMIUM

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On January 6 a Sauk County corn grower purchases
a December corn put option with a 2.40 strike
price for a premium of 16. The December corn
futures price was 2.47 when he bought his put.
What is the intrinsic value of his put? What is
the time value?
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On January 6 a Sauk County corn grower purchases
a December corn put option with a 2.40 strike
price for a premium of 16. The December corn
futures price was 2.47 when he bought his put.
What is the intrinsic value of his put? What is
the time value? The intrinsic value of his put
is 0 because the strike price (2.40) is less
than the price of the underlying futures contract
(2.47). The time value of the put option is
16. Since the intrinsic value is 0, the entire
premium is made up of time value.
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On January 6 a Sauk County corn grower purchases
a December corn put option with a 2.40 strike
price for a premium of 16. The December corn
futures price was 2.47 when he bought his put.
On November 1, the December corn futures price
is 2.65, local cash price is 2.40, and our
grower wants to sell his crop. What will he do
with his put option? What is the net price he
will receive for his crop?
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On January 6 a Sauk County corn grower purchases
a December corn put option with a 2.40 strike
price for a premium of 16. The December corn
futures price was 2.47 when he bought his put.
On November 1, the December corn futures price
is 2.65, local cash price is 2.40, and our
grower wants to sell his crop. What will he do
with his put option? What is the net price he
will receive for his crop? He will not do
anything with his put because it would probably
be worthless with a 2.65 futures price. The net
price for his corn is 2.40 - .16 2.24.
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On January 6 a Sauk County corn grower purchases
a December corn put option with a 2.40 strike
price for a premium of 16. The December corn
futures price was 2.47 when he bought his put.
On November 1, the December corn futures price
is 2.20, local cash price is 1.95, and our
grower wants to sell his crop. What will he do
with his put option? What is the net price he
will receive for his crop? He would most likely
sell his put option. At a 2.20 futures price,
the intrinsic value of his put would be 20 and
with several weeks until expiration, the time
value might be an additional 5. The net price
for his corn is 1.95 - 16 25 2.04.
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On January 6 a Sauk County soybean grower sold
his beans in the cash market but thinks the
market may rise in the next few months. He
decides to buy a May call option with a 7.80
strike price as a way to benefit from a rising
market. The premium for the option is 54 and
the May soybean futures price is 7.94. What is
the intrinsic value of the call? The time value?
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On January 6 a Sauk County soybean grower sold
his beans in the cash market but thinks the
market may rise in the next few months. He
decides to buy a May call option with a 7.80
strike price as a way to benefit from a rising
market. The premium for the option is 54 and
the May soybean futures price is 7.94. What is
the intrinsic value of the call? The time
value? The intrinsic value is 14. 7.94 -
7.80 14 The time value is 40. 54 - 14
40
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On January 6 a Sauk County soybean grower sold
his beans in the cash market but thinks the
market may rise in the next few months. He
decides to buy a May call option with a 7.80
strike price as a way to benefit from a rising
market. The premium for the option is 54 and
the May soybean futures price is 7.94. What
price will May futures need to reach prior to
expiration for the grower to be assured of a
positive return on his position?
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On January 6 a Sauk County soybean grower sold
his beans in the cash market but thinks the
market may rise in the next few months. He
decides to buy a May call option with a 7.80
strike price as a way to benefit from a rising
market. The premium for the option is 54 and
the May soybean futures price is 7.94. What
price will May futures need to reach prior to
expiration for the grower to be assured of a
positive return on his position? He would move
into positive territory at 8.35. The time value
slowly erodes as the contract expiration date
approaches. The intrinsic value needs to
increase during that time to cover the loss of
time value. In this case, he needs to add 40 of
intrinsic value or a 40 increase in the May
futures price to break even.