Risk Management for Dynamic Markets Options and Implied Volatility

Risk Management for Dynamic Markets Current Margin Environment Strategy Selection Core Strategies Delta Implied Volatility Recent Soybean Meal Strategy Example Current Implied Volatility Considerations

Current Margin Environment

Current Margins Quarter Margin ($/cwt) Current Percentile Average 70th Percentile 3Q 2016 7.63 61% 6.23 9.38 4Q 2016 -6.65 17% -0.49 2.37 1Q 2017 -3.08 16% 0.98 3.40 2Q 2017 5.46 20% 9.08 11.25

A Closer Look At 4th Quarter

4Q16 Margins Alalogs - Years of similar ‘All Hogs & Pigs’ numbers

4Q16 Margin Seasonal 10 year with 2014 10 year without 2014

4Q16 Margin 20 Year

Strategy Selection Core Strategies

Strategy Selection Margin Percentile Market Bias Considerations when deciding which strategy to employ Margin Percentile Higher margin percentiles = Stronger position Lower margin percentiles = Weaker position Market Bias Fundamentals Seasonals Analog Years

Strategy Selection Considerations when deciding which strategy to employ Try to quantify objective and bias information and rank on a scale from 0% to 100% of how much coverage you want to have on. In terms of hogs… If margins are approaching all time highs and you are bearish you probably would like to have a 100% position on If margins are average and your bias is neutral you may wish to have a 50% position on. If margins are poor and bias is bullish you may wish to have close to no position on.

Strategy Selection Considerations when deciding which strategy to employ Once you can quantify the strength of position you want to have on, the concept of a tool called Delta becomes important to understand.

Delta Delta measures an option strategy’s price sensitivity (in percentage terms) to the price movement of the underlying asset. A delta of +50% means that if the underlying asset increases by $1.00, the option strategy’s value will increase by $0.50. A delta of +30% means that if the underlying asset increases by $1.00, the option strategy’s value will increase by $0.30. Delta is the most important consideration when choosing an option strategy to protect against adverse price movement.

Strategy Selection Delta 100% 75% 60% 50% 40% 30% 20%

Implied Volatility The next consideration when determining the appropriate strategy is the implied volatility of the options. The measurement of unknown future volatility is called Implied Volatility. Implied Volatility helps to gauge when options are cheap or expensive Implied volatility tends to increase when The volatility of the underlying futures market increases Weather forecast start to turn negative (heat/drought) Approaching a USDA report which may produce a surprise. Option pricing is positively correlated with Implied Volatility (IV) When IV increases, the pricing of options increases. When IV decreases, the pricing of options decreases.

Implied Volatility Implied volatility’s effect on the pricing of an option can be significant. The measurement of this effect is called Vega. Vega measures the change in the price of an option due to a 1% change in implied volatility. For example, ATM DEC16 lean hog options currently have an IV of 18.6% and a Vega of 0.19. If the IV increases 1% to 19.6%, the price of an ATM put will increase by $0.19. Therefore, when IV is low, it makes sense to be net long options. Conversely, when IV is high, it makes sense to be short options.

All of these items are quantifiable at every moment Dec 2016 Lean Hogs as of the close on June 7

Strategy Selection Recent Soybean Meal Example

3Q16 Margin Example

Soybean Meal Example OCT16 Soybean Meal as of April 1, 2016

Soybean Meal Example

Soybean Meal Example For our example, the strategy chosen will have roughly a +40% delta. Neutral to slightly bearish bias On APR 1st, OCT Meal was trading for $278. The 280-330 call spread had a +40% delta. The 290 Call also had a +40% delta. Having 2 strategies with similar deltas, let’s examine which strategy makes the most sense given the existing IV environment. Where was implied volatility from a historical perspective at the time?

Soybean Meal Example On April 1, IV in OCT16 Soybean Meal Options was at a 10yr Low

Soybean Meal Example The 290call will increase in value if IV increases. The 280-330 call spread is more neutral IV because you are long 1 option and short one option With IV at a 10yr low, and a desired delta of 40%, it makes sense to choose an outright 290 call as a strategy to protect against higher prices. How did this turn out heading into the May 10th WASDE report?

On May 9th, OCT16 meal had increased from $278 to $335 Soybean Meal Example On May 9th, OCT16 meal had increased from $278 to $335

Soybean Meal Example Strategy gained $40.15 of $57.00 higher values or 70.4% of the rise in futures

Soybean Meal Example Strategy gained $23.10 of $57.00 higher values or 40.5% of the rise in futures

Reviewing this example: Soybean Meal Example Reviewing this example: The 290call participated in $40.15 of the rise in soybean meal futures, or 70%. In contrast, the 280-330 call spread participated in $23.10 of the move, or 40%. The portion of this discrepancy that can be explained by the change in IV is $4.50. The ability to quantify IV is a powerful tool which can add significant value to the producer’s bottom line.

Current Implied Volatility Considerations

Implied Volatility Dec hogs – IV between average and low. Consider buying puts or selling futures and buying calls

Implied Volatility Dec hogs – With futures at $66.87 consider buying a $66 put for $3.32

Implied Volatility Dec hogs – Or with futures at $66.87 consider selling futures and buying a $72 call for 1.50 to reopen upside.

Implied Volatility Dec corn– IV approaching average. Consider call spreads or 3-ways.

Implied Volatility Dec corn– With futures at $4.40 you can protect price from $4.50 up to $5.20 with the opportunity to participate down to $3.80 for 5 cents/bu.

Implied Volatility Dec meal– IV slightly above average. Consider call spreads or 3-ways.

Implied Volatility Dec meal– With futures at $404 you can protect price from $420 up to $480 with the opportunity to participate down to $350 for $5 ton.

Summary Deferred margins are not currently at attractive levels but there may still be a desire to manage risk while game planning for potential opportunities. When selecting the strength (Delta) of hedge strategies, margin percentiles and market bias need to be weighed. Delta is paramount when selecting appropriate strategy but IV is an important consideration as well. When considering equivalent Delta strategies, IV should be quantified to determine the most effective hedge against adverse price movement. The use of IV studies can add considerable value to a risk management program and a producer’s bottom line.

Hedge Design and Management Hedge Policy & Reporting Procedures Pricing Decision Guidance Models Risk Assessment There is a risk of loss in futures trading. The information contained in this publication is taken from sources believed to be reliable, but is not guaranteed by Commodity & Ingredient Hedging, LLC as to accuracy or completeness, and is intended for purposes of information and education only. Nothing therein should be considered as a trading recommendation by Commodity & Ingredient Hedging, LLC. The rules and regulations of the individual exchanges should be consulted as the authoritative source on all contract specifications and regulations. There is a risk of loss in all futures and options trading.