1. Risk Management for Dynamic Markets
Options and Implied Volatility

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

3. Current Margin Environment

4. 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

9. A Closer Look At 4th Quarter

10. 4Q16 Margins Alalogs - Years of similar ‘All Hogs & Pigs’ numbers

11. 4Q16 Margin Seasonal
10 year with 2014
10 year without 2014

12. 4Q16 Margin 20 Year

13. Strategy Selection Core Strategies

14. 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

15. 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.

16. 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.

17. 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.

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

19. 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.

20. 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 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.

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

22. Strategy Selection Recent Soybean Meal Example

23. 3Q16 Margin Example

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

25. Soybean Meal Example

26. 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 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?

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

28. Soybean Meal Example
The 290call will increase in value if IV increases. The 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?

29. 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

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

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

32. 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 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.

33. Current Implied Volatility Considerations

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

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

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

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

38. 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.

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

40. 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.

41. 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.

42. 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.