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Grain Marketing in the BioFuels Era: Session 2: Options Strategies: January 29

Grain Marketing in the BioFuels Era: Session 2: Options Strategies: January 29. Ethanol. For more information about reading charts, see CMS Disk 2, Unit 6 on Technical Analysis. Introduction to Options. (CMS Disk 1, Unit 2, modules 6a and 6b). Objectives.

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Grain Marketing in the BioFuels Era: Session 2: Options Strategies: January 29

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  1. Grain Marketing in the BioFuels Era:Session 2: Options Strategies: January 29 Ethanol

  2. For more information about reading charts, see CMS Disk 2, Unit 6 on Technical Analysis

  3. Introduction to Options (CMS Disk 1, Unit 2, modules 6a and 6b)

  4. Objectives • Become familiar with options terminology • Understand the advantages and disadvantages of options • Recognize when it is profitable to exercise an option.

  5. What is an Option? • Definition: An option is the right, but not the obligation, to buy or sell a futures contract at some predetermined price at anytime within a specified time period. • Options are derivative instruments. The option is written on an underlying asset—the futures contract.

  6. Calls and Puts • A call option is the right to buy the underlying futures contract at a predetermined price prior to expiration. • A put option is the right to sell an underlying futures contract at a predetermined price prior to expiration.

  7. Strike Price and Premium • The predetermined price at which an underlying futures contract may be bought or sold is called the strike price or the exercise price. • The premium is the amount paid for an option. (Paid up-front, no matter what).

  8. An Option Example December Corn $2.30 Call Underlying Asset Strike Price Option Type

  9. Strike Price Listing When an option is first listed, the strike prices include the closest strike to a futures price and then a predetermined number of strikes above and below. The number of strikes will vary by exchange. As market conditions change, additional strikes are listed.

  10. Options – CBOT Example (Jan 19, 2007)

  11. Premiums • Premiums are determined in an open outcry auction. It’s important to realize that all of the options terms are set by the exchange except for the premium. • The premium is paid up-front by the buyer and must be paid whether the option is exercised or not.

  12. Option Alternatives • The buyer of the option may do the following prior to the option expiration: • exercise the option (get the futures position) • offset or liquidate the position • Buy a put ---sell same put • Buy a call---sell same call • allow the option to expire. No obligation with an option purchase!

  13. When Is an Option Exercised? • Options can be exercised if profitable. • a put option is profitable when the option strike is above the underlying futures price (the right to sell higher than the current futures price) • a call option is profitable when the strike price is below the underlying futures price (the right to buyer below the current market)

  14. What About the Sellers of Options? • Option Seller (Writer): • receives the premium from the option buyer, and • must take the opposite position if the option is exercised. As a result, • the option seller must post margin, and • may face margin calls.

  15. Option Jargon • In-the-money: An option is said to be in-the-money if it is profitable to exercise. • Out-of-the-money: An option is said to be out-of-the-money if a loss would result if it were exercised. • At-the-money: An option is at-the-money if its strike price is the same as its underlying futures price.

  16. Valuing Options in the BioFuels Era

  17. What Determines an Options Value? • Intrinsic Value: the positive value if an option were to be exercised • Put: Strike Price is Above the Current Futures • Call: Strike price is below the current Futures 2. Days to Expiration -Value increases as time to expiration increases

  18. What Determines an Options Value? • Volatility of Underlying Futures • Higher volatility increases option premiums • Interest Rates • Higher interest rates lower option premiums

  19. BioFuels Era Impact on Options Value • With the increase in biofuels demand for corn and uncertainty about supply, volatility of futures has increased! • Average volatility from 1980-2006: 18.3% • Average volatility in 2005: 21.9% • Average volatility in 2006: 28.8% • This makes option premiums greater than when prices were lower and less volatile

  20. Biofuels Era Impact on Options Value (%)

  21. Hedging with Options (CMS Disk 1, Unit 2, module 7)

  22. Objectives • Understand the mechanics of hedging with options • Establish the advantages and disadvantages of options hedges • Complete examples of options hedges

  23. Hedging with Options • A long cash market position can be hedged with options to provide a minimum (floor) price, but also enable higher prices if subsequent futures prices were to rise ( a floor price but no ceiling). • Two common strategies: • Buy a put option • Sell cash grain and buy an OTM call option • “Sell and defend” • Both strategies set a price floor price and also allow you to gain if futures prices subsequently increase.

  24. Why Options Over Futures? • Seller’s/Buyer’s Remorse: Option hedgers can take advantage of favorable price movements. • Posting and Managing Margin: Buyers of options do not post margin (although writers do).

  25. Which Month and Strike for You to Buy? 1. Contract Month Time Frame of the Objective 2. Cost of premium 3. Protection level: What is the tradeoff between the premium and the protection? -Lower protection---lower costs -Higher protection---higher costs 4. Outlook – what is likely to happen to the underlying futures price. -----------Plus some more---------

  26. Also for you to consider 5. Your risk bearing ability 6. Your costs of production 7. Your pricing objectives 8. Your understanding of pricing alternatives

  27. A Soybean Example … • It’s late Spring and you want to protect against low soybean prices at harvest. What month? What option type? Which strike do you select? • November futures: $5.75 • Put option @ $5.75: 25 cents • Put option @ $5.50: 15 cents

  28. Buy a Put(Strategy #2, p50) • Goal: Establish a price floor • Advantage: Establishes a floor price but not a ceiling • Disadvantage: Premium cost

  29. Example—Buy a Put • In May, an Indiana corn producer seeks to protect the value of corn sold at harvest. • Question: What type of option should this producer consider buying? Why? What month? • Question: What are the advantages of this option hedge over futures hedging?

  30. Example—Buy a Put • Current Dec07 Futures @ $3.90/bu. • Premium for $3.80 put is $0.35/bu. • Expected Basis is $0.20 under. • What minimum price is established?

  31. Example—Buy a Put Minimum Price = Strike Price - Premium - Expected Basis - Hedging Costs (Interest/Brokerage Fee) Min. Price = $3.80 - $0.35 - $0.20- $0.02 = 3.23

  32. Example--Put, Prices Fall At marketing in November, suppose prices fall. Futures Prices @ $3.00 Cash Prices @ $2.80 What is the net price received ? • Net Price = • Futures Price +(-) Basis - Premium - Hedging Costs • + Options Gain

  33. The Minimum Price! Example--Put, Prices Fall Net Price = $3.00 (Futures Price) - 0.20 (Basis) -0.35 (premium) -0.02 +0.80 (Options Gain:$3.80-3.00 ) $3.23 Net Price per bushel Cash Price • Net Price = • Futures Price +(-) Basis - Premium - Hedging Costs • + Options Gain (Strike-Futures)

  34. Example--Put ,Prices Increase Slightly Net Price = $4.00 (Futures Price) -0.20 (Basis) -0.35 (premium) -0.02 (hedging) costs +0 (Options Gain:$3.80-4.00=0 ) $3.43 Net Price per cwt • Net Price = • Futures Price +(-) Basis - Premium - Hedging Costs • + Options Gain

  35. Above the Minimum Price! Example--Put, Price Increase! Yahoo! Net Price = $4.40 (Futures Price) -0.20 (Basis) -0.35 (premium) -0.02 (hedging costs) +0.00 (Options Gain) $3.83 Net Price per cwt • Net Price = • Futures Price +(-) Basis - Premium - Hedging Costs • + Options Gain

  36. Buy a Put Example Summary Buying a put establishes a minimum price Strike: $3.80 Premium: $0.35 Basis: -$0.20 Price Floor Upside Potential

  37. Buy a Put Strike Price Tradeoff • You have a choice of different strike prices • Assume basis is .20 under and hedging costs of 2 cents $3.50 Dec07 corn put costs $0.18 $3.90 Dec07 corn put costs $0.38 $4.40 Dec07 corn put costs $0.71

  38. Strike Price/Premium Tradeoff • Put: • Higher strike price means more price protection, but it costs more • Lower strike price costs less, but it means less price protection • Call: • Lower strike price means more chance of payoff, but it costs more • Higher strike price costs less, but means less chance of payoff (futures price has to increase more to get above the strike price)

  39. Sell Cash and Buy OTM Call(Strategy #5, p. 57) • Strategy is called a synthetic put because it establishes a price floor and leaves upside potential in place (no ceiling) • Pre-harvest combine a forward contract with OTM call • Post-harvest combine cash sale with OTM call

  40. Example—Sell Cash Grain in March and Buy OTM Call (Weather Protection) • Current July07 Futures on March 1 are $4.25/bu. • Cash price on March 1 is $4.00. Corn delivered and sold at $4.00. • Premium for $4.50 July call is $0.28 • A $4.50 call is OTM—this option allows the owner to gain if July futures move above $4.50. Since the current July futures is $4.25, they cannot start gaining until the July futures move up $.25 per bushel. (They can gain after the market moves up $.25/bu.) • What minimum price is established?

  41. Example—Sell Cash Grain, Buy OTM Call Minimum Price = Cash Price - Premium - Hedging Costs (Interest/Brokerage Fee) Min. Price = $4.00 - $0.28- $0.02 = $3.70/bushel

  42. Example—Cash & Call, Prices Fall Say by June weather has favorable and July futures drop. July Futures Prices @ $3.25 What is the net price received ? • Net Price = • Cash Price - Premium - Hedging Costs + Options Gain

  43. The Minimum Price! Example—Cash & Call, Prices Fall Net Price = $4.00 (Cash Price) -0.28 (premium) -0.02 +0 (no gain on options) $3.70 Net Price per bu • Net Price = • Cash Price - Premium - Hedging Costs + Options Gain

  44. The Minimum Price! Example—Cash & Call , Futures Price Increases Slightly (from $4.25 to $4.50) Net Price = $4.00 (Cash Price) -0.28 (premium) -0.02 (hedging) costs +0 (Options Gain) $3.70 Net Price per cwt • Net Price = • Cash Price - Premium - Hedging Costs + Options Gain

  45. Above the Minimum Price! Example—Cash & Call, Futures Price Increases (from to $5.00) Yahoo! Net Price = $4.00 (Cash Price) -0.28 (premium) -0.02 (hedging costs) +0.50 (Options Gain: $5.00-$4.50) $4.20 Net Price per bu • Net Price = • Cash Price - Premium - Hedging Costs + Options Gain

  46. Selling $4.00 Cash and buying a $4.50 Call (Minimum cash price, with chance to gain if futures move above $4.50). Call Strike: $4.50 Premium: $0.28 Basis: $0.00 Price Floor Upside Potential

  47. Sell a Call(Strategy #3, p. 52) • Goal: Increase selling price • Advantage: Receive premium • Disadvantage: Little price protection and sets maximum price (price ceiling)

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