Options on Futures

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Options on Futures

• Separate market
• Option on the futures contract
• Can be bought or sold
• Behave like price insurance
• Is different from the new insurance products

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Options on Futures

• Two types of optionsFour possible positions
• Put
• Buyer
• Seller
• Call
• Buyer
• Seller

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Put option

• The Buyer pays the premium and has the right, but
  not the obligation to sell a futures contract at
  the strike price.
• The Seller receives the premium and is obligated
  to buy a futures contract at the strike price.

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Call option

• The Buyer pays a premium and has the right, but
  not the obligation to buy a futures contract at
  the strike price.
• The Seller receives the premium but is obligated
  to sell a futures contract at the strike price.

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Options as price insurance

• Person wanting protection pays a premium
• If damage occurs the buyer is reimbursed for
  damages
• Seller keeps the premium but must pay for damages

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Options

• May or may not have value at end
• The right to sell at 2.20 has no value if the
  market is above 2.20
• Can be offset, exercised, or left to expire
• Calls and puts are not opposite positions of the
  same market. They are different markets.

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Strike price

• Level of price insurance
• Set by the exchange (CME, CBOT)
• A range of strike prices available for each
  contract

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Premium

• Is traded in the option market
• Buyers and sellers establish the premium through
  open out cry in the trading pit.
• Different premium
• For puts and calls
• For each contract month
• For each strike price

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Premium

• Depends on five variables
• Strike price
• Price of underlying futures contract
• Volatility of underlying futures
• Time to maturity
• Interest rate

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Premium relationship to

• Strike price
• Increases with the level of protection
• Futures volatility
• Increases with riskiness of the contract

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Premium relationship to

• Time to maturity
• Decreases exponentially as contract expires
• Reflects carrying charge and risk
• Interest rates
• Increases as rates increase

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Premium relationship to

• Underlying futures price
• In-the-money
• At-the-money
• Out-of-the-money

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In-the-money

• If expired today it has value
• Put futures price below strike price
• Call futures price above strike price

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At-the-money

• If expired today it would breakeven
• Strike price nearest the futures price

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Out-of-the-money

• If expired today it does not have value
• Put futures price above strike price
• Call futures price below strike price

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Option buyer alternatives

• Let option expire
• Typically when it has no value
• Exercise right
• Take position in futures market
• Buy or sell at strike price
• Re-sell option rights to another

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Buyer decision depends upon

• Remaining value and costs of alternative
• Time mis-match
• Most options contracts expire 2-3 weeks prior to
  futures expiration
• Cash settlement expire with futures
• Improve basis predictability

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Option seller

• Obligated to honor option contract
• Can buy back option to offset position
• Now out of market

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Put option example

• A farmer has corn to sell after harvest.
• 1) In May, buy a 2.80 Dec Corn Put
• Expected basis -0.25
• Premium 0.15
• Commission 0.01
• Expected minimum price (EMP)
• SP Basis - Prem - Comm 2.39
• Notice that you subtract the premium because it
  works against you and you are trying to reduce
  cost.

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Put option example Lower

• 2) At harvest futures prices lower.
• Futures 2.50
• Cash market 2.25
• Option value 2.80-2.50 0.30
• Net price Cash Return - Cost 2.25 0.30
  - 0.15 - 0.01 2.39

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Put option example Higher

• 3) At harvest futures prices higher.
• Futures 3.15
• Cash market 2.90
• Option value 0
• Net price Cash Return - Cost
• 2.90 0 - 0.15 - 0.01 2.74

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Call option example

• A feedlot wants to buy corn to feed after
  harvest.
• 1) In May, buy a 3.00 Dec Corn Call
• Expected basis -0.25
• Premium 0.20
• Commission 0.01
• Expected maximum price (EMP)
• SP Basis Prem Comm 2.96
• Notice that you add the premium because it works
  against you and you are trying to reduce cost.

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Call option example Lower

• 2) At harvest futures prices lower.
• Futures 2.50
• Cash market 2.25
• Option value 0
• Net price Cash - Return Cost
• 2.25 - 0 0.20 0.01 2.46

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Call option example Higher

• 3) At harvest futures prices higher.
• Futures 3.15
• Cash market 2.90
• Option value 3.15-3.00 0.15
• Net price Cash - Return Cost
• 2.90 - 0.15 0.20 0.01 2.96

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Net Price with Options

• Buy Put
• Minimum price
• Cash price - premium - comm
• Buy Call
• Maximum price
• Cash price premium comm

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Livestock Risk Protection (LRP)

• Coverage for hogs, fed cattle and feeder cattle
• 70 to 95 guarantees available, based on CME
  futures prices.
• Coverage is available for up to 26 weeks out for
  hogs and 52 for cattle.

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Livestock Risk Protection

• Guarantees available are posted at
  www.rma.usda.gov/tools/
• Posted after the CME closes each day until 900
  am central time the next working day.
• Assures that guarantees reflect the most recent
  market movements.

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Size of Coverage

• Futures and options have fixed contract sizes
• Hogs 400 cwt. or about 150 head
• Fed cattle 400 cwt. or about 32 head
• Feeder cattle 500 cwt., 60-100 head
• LRP can be purchased for any number of head or
  weight

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Some Risks Remain

• LRP, LGM do not insure against production risks
• Futures prices and cash index prices may differ
  from local cash prices (basis risk)
• Selling weights and dates may differ from the
  guarantees

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Expiration Date of Coverage

• LRP ending date is fixed. Price may change after
  date of sale.
• Hedge or options can be lifted at any time before
  the contract expires.

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Who can benefit from LGM/LRP?

• Producers who depend on the daily cash market or
  a formula related to it.
• Producers with low cash reserves.
• Smaller producers who do not have the volume to
  use futures contracts or put options.
• Producers who prefer insurance to the futures
  market. No margin account.

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LRP Analyzer

• Covers swine, fed cattle, feeders
• Compares net revenue distribution
• No risk protection
• LRP
• Hedge
• Put options

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Case Example

• Small cow herd producer will have 62 head of 650
  pound steer calves to sell in 4 months.
• What price will LRP lock in?
• How much will it cost?
• How does LRP compare to futures?

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Livestock Gross Margin

• Cattle
• Calves
• Yearlings
• Hogs
• Farrow to finish
• Finishing feeder pig
• Finishing SEW pig

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Livestock Gross Margin

• Insures a margin between revenue and cost of
  major inputs
• Hogs
• Value of hog corn and SBM costs
• Cattle
• Value of cattle feeder cattle and corn
• Protects against decreases in cattle/hog prices
  increases in input costs

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LGM Hogs

• Farrow to Finish option
• Gross margin per hogt
• 2.50.74LeanHog Pricet
• - 13.22 bu. Corn Pricet-3
• - (188.52 lb./2000 lb.) SoyMeal Pricet-3
• Finish Only option
• Gross margin per hogt
• 2.50.74Lean Hog Pricet
• - 10.19 bu. Corn Pricet-2
• - (147.31 lb./2000 lb.) SoyMeal Pricet-2

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LGM-Cattle

• Uses futures markets to lock in the average
  expected gross margin for fed cattle to be sold
  in each of the next ten months
• Protects against decreases in live cattle prices
  increases in feeder cattle prices and increases
  in feed costs

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LGM-Cattle

• Yearling GM 12.5 x Basis adjusted LC futures
• - 7.5 x Basis adjusted FC futures
• - 57.5 x Basis adjusted Corn futures
• Calf  GM 11.5 x Basis adjusted LC futures
• - 5.5 x Basis adjusted FC futures
• - 55.5 x Basis adjusted Corn futures

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Learn More About Risk Tools

• Livestock Revenue Protection
• Livestock Gross Margin
• http//www.rma.usda.gov/livestock/
• Factsheets
• Premium calculator
• Livestock Futures and Options
• Historic basis patterns
• www.extension.iastate.edu/agdm
• Decision file B1-50