Options Strategies Commodity Marketing Activity Chapter #6

Option Premiums l EX: corn put option premium = $.20 l Corn contract = 5,000 bu l Buyer of a corn put pays $1,000 ($.20 x 5,000) to the seller of the put l If the option is worthless at the time he is ready to sell his corn, let it expire, and lose $1,000 l If the value is above $0, he can offset it by selling it back and MAY gain a profit l No Margin Deposit is required

Option Premiums l The Seller takes a greater risk l If Seller wants to OFFSET his put, he must buy the same futures contract –margin deposit required –to guarantee against any loss l Producer must pay a commission to broker to trade options

Hog Producer Example l In June, you expect to have 525 hogs ready for market in November l Local buyer offers $44.50/cwt, your target is higher l You want protection if prices fall, but want to take advantage if prices rise l First Step = set your target price

Target Price Strike Price$52.00$50.00$46.00 Prem. Cost$ 4.50$ 2.75$.75 Expect Basis $-2.00$-2.00$-2.00 Target Price$45.50$45.25$43.25 l You want to establish a minimum price of $45/cwt l You will need 3 options to protect 400 hogs l You have the $3,300 ($2.75 x 400 per option) so you buy the $50 Dec. put option

Prices Fall l In November, futures fall to $45, local cash price is $43 (basis = -$2) l Dec 50 hog put option premium = $5 l You sell 3 Dec 50 puts and get the $5 ($2.25/cwt profit) l You sell hogs locally for $43 l Total income = $43 + $2.25 = $45.25 l $2,700 gain over cash market alone

Prices Rise l Futures rise to $49 l Sell Dec 50 put for premium of $1 (loss of $1.75) l Cash Price = $47 l Total Income = $47 - $1.75 = 45.25

Prices Rise l Futures price = $52 l Put Option is worthless l Let Option expire, lose $2.75 l Sell hogs for $50 l Total income = $50 - $2.75 = $47.25

Storage Stragegy l November, you have 35,000 bu of corn l Cash price = $2.20 l Cash Forward Contract (July) = $2.60 l Storage cost is $.28/bu l Want to lock in min. of $2.60 and benefit of price rises l Expected Basis = -10 cents l Calculate Target Price

Target Price Strike Price$3.00$2.90$2.80 Prem. Cost$.22$.15$.10 Exp. Basis$-.10$-.10$-.10 Target Price$2.68$2.65$2.60 Cur. Cash Pr.$2.20$2.20$2.20 Storage Gain$.48$.45$.40

Action l You will need 7 option contracts l Cost of Premiums will be: –$.22 x 35,000 = $7,700($3 strike) or –$.15 x 35,000 = $5,250($2.90 strike) l Based on cash flow, you choose $2.90 strike price

Prices Rise l In July, Futures price = $3.10, and Cash Price = $3.00 l July 290 put is worthless, let it expire, lose $.15/bu l Sell corn for $3 in cash market l Total income = $ $.15 = $2.85 vs $2.30 if Forward Contract

Prices Fall l Futures price = $2.35, cash = $2.25 l Sell July Corn 290 puts at higher premium ($.55) for profit of $.40/bu l Total income = $ $.40 = $2.65

Purchasing Strategy l As a purchaser of feeder cattle, you buy CALL options to protect yourself against price increases while leaving yourself open to profit from price decreases l In July, you planning to buy 240 feeder cattle in December l Establish Target Price

Target Price Strike Price$64.00$62.00$60.00 Prem. Cost$ 2.55$ 3.90$ 5.70 Expect Basis $+1.00$+1.00 $+1.00 Target Price$67.55$66.90$66.70 l Target max. purchase price = $67/cwt, rule out 64 call option l Total premium for 4 calls: –$3.90 x 440 cwt x 4 = $6,864 (62 call) or –$5.70 x 440 cwt x 4 = $10,032 (60 call)

Prices Fall l Buy 4 January feeder cattle 62 calls at $3.90/cwt l In December, futures price = $58, cash price = $59 l Jan. Calls are worthless, let expire, lose $6,864 l Buy feeder cattle at $59/cwt l Total cost = $59 + $3.90 = $62.90

Prices Rise l Futures price = $70, cash price = $71 l Sell option for $8 ($4.10 profit) l Buy cattle for $71 l Total cost = $71 - $4.10 = $66.90