Options on Futures uSeparate market uOption on the futures contract uCan be bought or sold uBehave like price insurance –Is different from the new insurance products

Options on Futures uTwo types of options Four possible positions –Put »Buyer »Seller –Call »Buyer »Seller

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

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

Options as price insurance uPerson wanting protection pays a premium uIf damage occurs the buyer is reimbursed for damages uSeller keeps the premium but must pay for damages

Options uMay or may not have value at end –The right to sell at $2.20 has no value if the market is above $2.20 uCan be offset, exercised, or left to expire uCalls and puts are not opposite positions of the same market. They are different markets.

Strike price uLevel of price insurance uSet by the exchange (CME, CBOT) uA range of strike prices available for each contract

Premium uIs traded in the option market –Buyers and sellers establish the premium through open out cry in the trading pit. uDifferent premium –For puts and calls –For each contract month –For each strike price

Premium uDepends on five variables –Strike price –Price of underlying futures contract –Volatility of underlying futures –Time to maturity –Interest rate

Premium relationship to: uStrike price –Increases with the level of protection uFutures volatility –Increases with riskiness of the contract

Premium relationship to: uTime to maturity –Decreases exponentially as contract expires –Reflects carrying charge and risk uInterest rates –Increases as rates increase

Premium relationship to: uUnderlying futures price –In-the-money –At-the-money –Out-of-the-money

In-the-money uIf expired today it has value uPut: futures price below strike price uCall: futures price above strike price

At-the-money uIf expired today it would breakeven uStrike price nearest the futures price

Out-of-the-money uIf expired today it does not have value uPut: futures price above strike price uCall: futures price below strike price

Option buyer alternatives uLet option expire –Typically when it has no value uExercise right –Take position in futures market –Buy or sell at strike price uRe-sell option rights to another

Buyer decision depends upon uRemaining value and costs of alternative uTime mis-match –Most options contracts expire 2-3 weeks prior to futures expiration –Cash settlement expire with futures –Improve basis predictability

Option seller uObligated to honor option contract uCan buy back option to offset position –Now out of market

Put option example uA 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.

Put option example Lower 2) At harvest futures prices lower. Futures = $2.50 Cash market =$2.25 Option value = $ =$0.30 Net price = Cash + Return - Cost = $ = $2.39

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 = $ = $2.74

Call option example uA 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.

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 = $ = $2.46

Call option example Higher 3) At harvest futures prices higher. Futures = $3.15 Cash market =$2.90 Option value = $ =$0.15 Net price = Cash - Return + Cost = $ = $2.96

Net Price with Options uBuy Put –Minimum price –Cash price - premium - comm uBuy Call –Maximum price –Cash price + premium + comm

Livestock Risk Protection (LRP) uCoverage for hogs, fed cattle and feeder cattle u70% to 95% guarantees available, based on CME futures prices. uCoverage is available for up to 26 weeks out for hogs and 52 for cattle.

Livestock Risk Protection uGuarantees available are posted at: uPosted after the CME closes each day until 9:00 am central time the next working day. uAssures that guarantees reflect the most recent market movements.

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., head uLRP can be purchased for any number of head or weight

Some Risks Remain uLRP, LGM do not insure against production risks uFutures prices and cash index prices may differ from local cash prices (basis risk) uSelling weights and dates may differ from the guarantees

Expiration Date of Coverage uLRP ending date is fixed. Price may change after date of sale. uHedge or options can be lifted at any time before the contract expires.

Who can benefit from LGM/LRP? uProducers who depend on the daily cash market or a formula related to it. uProducers with low cash reserves. uSmaller producers who do not have the volume to use futures contracts or put options. uProducers who prefer insurance to the futures market. No margin account.

LRP Analyzer uCovers swine, fed cattle, feeders uCompares net revenue distribution –No risk protection –LRP –Hedge –Put options

Case Example uSmall cow herd producer will have 62 head of 650 pound steer calves to sell in 4 months. uWhat price will LRP lock in? uHow much will it cost? uHow does LRP compare to futures?

Livestock Gross Margin uCattle –Calves –Yearlings uHogs –Farrow to finish –Finishing feeder pig –Finishing SEW pig

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

LGM Hogs uFarrow to Finish option uGross margin per hog t = –2.5*0.74*LeanHog Price t – bu. * Corn Price t -3 –- ( lb./2000 lb.) * SoyMeal Price t -3 uFinish Only option uGross margin per hog t = –2.5*0.74*Lean Hog Price t – bu. * Corn Price t -2 –- ( lb./2000 lb.) * SoyMeal Price t -2

LGM-Cattle uUses futures markets to lock in the average expected gross margin for fed cattle to be sold in each of the next ten months uProtects against decreases in live cattle prices increases in feeder cattle prices and increases in feed costs

LGM-Cattle Yearling GM = 12.5 x Basis adjusted LC futures x Basis adjusted FC futures x Basis adjusted Corn futures Calf GM = 11.5 x Basis adjusted LC futures x Basis adjusted FC futures x Basis adjusted Corn futures

Learn More About Risk Tools uLivestock Revenue Protection uLivestock Gross Margin uhttp:// –Factsheets –Premium calculator uLivestock Futures and Options uHistoric basis patterns uwww.extension.iastate.edu/agdmwww.extension.iastate.edu/agdm –Decision file B1-50