Options Strategies

1. Options Strategies Commodity Marketing Activity Chapter #6

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

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

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

5. 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 • You want to establish a minimum price of $45/cwt • You will need 3 options to protect 400 hogs • You have the $3,300 ($2.75 x 400 per option) so you buy the $50 Dec. put option

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

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

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

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

10. 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

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

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

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

14. Purchasing Strategy • 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 • In July, you planning to buy 240 feeder cattle in December • Establish Target Price

15. 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 • Target max. purchase price = $67/cwt, rule out 64 call option • 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)

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

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