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

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

Ethanol

For more information about reading charts, seeCMS Disk 2, Unit 6 onTechnical Analysis

Introduction to Options

(CMS Disk 1, Unit 2, modules 6a and 6b)

Objectives

• Become familiar with options terminology

• Understand the advantages and disadvantages of options

• Recognize when it is profitable to exercise an option.

What is an Option?

• Definition: An option is the rightright, but not the obligation,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.

Calls and Puts

• A call optioncall option is the right to buy the underlying futures contract at a predetermined price prior to expiration.

• A put optionput option is the right to sell an underlying futures contract at a predetermined price prior to expiration.

Strike Price and Premium

• The predetermined price at which an underlying futures contract may be bought or sold is called the strike pricestrike price or the exercise priceexercise price.

• The premiumpremium is the amount paid for an option. (Paid up-front, no matter what).

An Option Example

December Corn $2.30 Call

Underlying Asset

Strike Price

Option Type

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 then a predetermined number of strikes above and belowstrikes above and below. The number of strikes will vary by exchange.

As market conditions change, additional strikes are listed.

Options – CBOT Example (Jan 19, 2007)

Corn cents/bu

Futures = 390 ¾ Call Put

Strike Price Dec07 Dec07

370 49 29 3/8

380 45 3/8 35

390 41 7/8 41 ¼

400 38 7/8 47 5/8

410 35 7/8 --

420 33 61 ¼

Premiums

• PremiumsPremiums 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.

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!

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)

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.

Option Jargon

• In-the-moneyIn-the-money: An option is said to be in-the-money if it is profitable to exercise.

• Out-of-the-moneyOut-of-the-money: An option is said to be out-of-the-money if a loss would result if it were exercised.

• At-the-moneyAt-the-money: An option is at-the-money if its strike price is the same as its underlying futures price.

Valuing Options in the BioFuels Era

What Determines an Options Value?

1. 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

What Determines an Options Value?

3. Volatility of Underlying Futures

• Higher volatility increases option premiums

4. Interest Rates

• Higher interest rates lower option premiums

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

Biofuels Era Impact on Options ValueValue of $3.60 Dec07 Corn Put Premium

Depending on Volatility

$0.00

$0.05

$0.10

$0.15

$0.20

$0.25

$0.30

$0.35

$0.40

$0.45

16 18 20 22 24 26 28 30 32 34 36 38 40

Volatility

Pu

t P

rem

ium

($/b

u)

(%)

Hedging with Options

(CMS Disk 1, Unit 2, module 7)

Objectives

• Understand the mechanics of hedging with options

• Establish the advantages and disadvantages of options hedges

• Complete examples of options hedges

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.

Why Options Over Futures?

• Seller’s/Buyer’s RemorseSeller’s/Buyer’s Remorse: Option hedgers can take advantage of favorable price movements.

• Posting and Managing MarginPosting and Managing Margin: Buyers of options do not post margin (although writers do).

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---------

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

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

Buy a Put(Strategy #2, p50)

• Goal: Establish a price floor

• Advantage: Establishes a floor price but not a ceiling

• Disadvantage: Premium cost

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?

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?

Example—Buy a Put

Min. Price = $3.80 - $0.35 - $0.20- $0.02 = 3.23

Minimum Price = Strike Price

- Premium

- Expected Basis- Hedging Costs (Interest/Brokerage Fee)

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

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

Example--Put, Prices Fall

Cash Price

The MinimumPrice!

Net Price =Futures Price +(-) Basis - Premium - Hedging

Costs + Options Gain (Strike-Futures)

Example--Put ,Prices Increase Slightly


-0.20 (Basis)

-0.35 (premium)

-0.02 (hedging) costs

+00 (Options Gain:$3.80-4.00=0 )

$3.43 Net Price per cwt


Costs + Options Gain

Example--Put, Price Increase! Yahoo!


-0.20 (Basis)

-0.35 (premium)

-0.02 (hedging costs)

+0.000.00 (Options Gain)


Above the MinimumPrice!


Costs + Options Gain

Buy a Put Example Summary

PriceFloor

UpsidePotential

Buying a put establishes a minimum priceStrike: $3.80Premium: $0.35 Basis: -$0.20

Futures Cash Buy $3.80 Put

3.40 3.20 3.23

3.60 3.40 3.23

3.80 3.60 3.23

4.00 3.80 3.43

4.20 4.00 3.63

4.40 4.20 3.83

4.60 4.40 4.03

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



Futures Cash Buy $3.50 Put Buy $3.90 Put Buy $4.40 Put

$3.10 $2.90 $3.10 $3.30 $3.47

$3.30 $3.10 $3.10 $3.30 $3.47

$3.50 $3.30 $3.10 $3.30 $3.47

$3.70 $3.50 $3.30 $3.30 $3.47

$3.90 $3.70 $3.50 $3.30 $3.47

$4.10 $3.90 $3.70 $3.50 $3.47

$4.30 $4.10 $3.90 $3.70 $3.47

$4.50 $4.30 $4.10 $3.90 $3.57

$4.70 $4.50 $4.30 $4.10 $3.77

$4.90 $4.70 $4.50 $4.30 $3.97

$5.10 $4.90 $4.70 $4.50 $4.17

$5.30 $5.10 $4.90 $4.70 $4.37

$5.50 $5.30 $5.10 $4.90 $4.57

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)

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

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?

Example—Sell Cash Grain, Buy OTM Call

Min. Price = $4.00 - $0.28- $0.02 = $3.70/bushel

Minimum Price = Cash Price

- Premium- Hedging Costs (Interest/Brokerage Fee)

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

Net Price = $4.00 (Cash Price)

-0.28 (premium)

-0.02

+0 (no gain on options)

$3.70 Net Price per bu

Example—Cash & Call, Prices Fall

The MinimumPrice!

Net Price =Cash Price - Premium - Hedging Costs + Options Gain

Example—Cash & Call , Futures Price Increases Slightly (from $4.25 to $4.50)


-0.28 (premium)


+00 (Options Gain)


The MinimumPrice!

Net Price =Cash Price - Premium - Hedging Costs + Options

Gain

Example—Cash & Call, Futures Price Increases (from to $5.00) Yahoo!


-0.28 (premium)


+0.50 (Options Gain: $5.00-$4.50)

$4.20 Net Price per bu

Above the MinimumPrice!

Net Price =Cash Price - Premium - Hedging Costs + Options Gain

PriceFloor

UpsidePotential

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: $4.50Premium: $0.28 Basis: $0.00

Futures Cash Sell 4.00 Cash & Buy $4.50 Call

3.80 3.80 3.70

4.00 4.00 3.70

4.20 4.20 3.70

4.40 4.40 3.70

4.60 4.60 3.80

4.80 4.80 4.00

5.00 5.00 4.20

Sell a Call(Strategy #3, p. 52)

• Goal: Increase selling price

• Advantage: Receive premium

• Disadvantage: Little price protection and sets maximum price (price ceiling)

Sell a Call

• Current Dec07 Futures @ $3.90/bu.

• Premium for $4.00 call is $0.36/bu.

• Expected Basis is $0.20 under.

• What maximum price is established?

Example—Sell a Call

Max. Price = $4.00 + $0.36 - $0.20- $0.02 = 4.14

Maximum Price = Strike Price

+ Premium

- Expected Basis- Hedging Costs (Interest/Brokerage Fee)

Example—Sell Call, 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 Loss


- 0.20 (Basis)

+0.36 (premium)

-0.02

+0 (Options Loss:$3.00-4.00 )

$3.14 Net Price per bushel

Example—Sell Call, Prices Fall

Cash Price

Net Price =Futures Price +(-) Basis + Premium - Hedging

Costs - Options Loss (Futures-Strike)

Example—Sell Call ,Prices Increase Slightly


-0.20 (Basis)

+0.36 (premium)


-.20 (Options Loss:$4.00-4.20=-.20 )

$4.14 Net Price per cwtNet Price =

Futures Price +(-) Basis + Premium - Hedging Costs

- Options Loss

The Maximum Price

Example—Sell Call, Price Increase


-0.20 (Basis)

+0.36 (premium)


-0.600.60 (Options Loss)


Still MaximumPrice

Net Price =Futures Price +(-) Basis + Premium - Hedging

Costs - Options Loss

Sell a Call Example Summary

Price Ceiling

Selling a call establishes a maximum priceStrike: $4.00Premium: $0.36 Basis: -$0.20

Futures Cash Sell $4 Call

3.40 3.20 3.54

3.60 3.40 3.74

3.80 3.60 3.94

4.00 3.80 4.14

4.20 4.00 4.14

4.40 4.20 4.14

4.60 4.40 4.14

Limited downside protection

Fence (Window): Buy a Put and Sell a Call (Strategy #4, p. 53)

• Goal: Provides both floor price and ceiling price. Locks in cheap price protection

• Advantage: Cost of floor price protection (put) is reduced by income from selling call

• Disadvantage: Limited upward price potential (establishes a ceiling price)

Fence (Window) : Buy a Put and Sell a Call

• Combine previous two strategies with OTM Put and OTM Call

• Current Dec07 Futures @ $3.90/bu.– Premium for $4.20 call is $0.30/bu.– Premium for $3.60 put is $0.26/bu.

• Expected Basis is $0.20 under • What minimum and maximum prices

are established?

Fence or Window• Total premiums = -$0.26+$0.30 = +$0.04

• Buy Put establishes minimum price (price floor)Min Price = Put Strike Price + Total Premium- Expected

Basis - Hedging Costs

Minimum price=3.60+0.04-0.20-0.04=3.40• Sell Call establishes maximum price (price ceiling)Max Price = Call Strike Price + Total Premium- Expected

Basis - Hedging Costs

Maximum price = 4.20+0.04-0.20-0.04 = 4.00

Fence Example Summary

PriceFloor

Price Ceiling

Buy $3.60 Put for $0.26 per bushelSell $4.20 Call for $0.30 per bushel with a Basis = -$0.20

Futures Cash Fence: Buy $3.60 Put & Sell 4.20 Call

3.40 3.20 3.40

3.60 3.40 3.40

3.80 3.60 3.60

4.00 3.80 3.80

4.20 4.00 4.00

4.40 4.20 4.00

4.60 4.40 4.00

Open window

Before Hedging with Options…

• Calculate minimum price

– Is this price above loan?

• An LDP is a free put—no need to buy another

• Is this price high enough to cover your costs?

• Is the option strategy the best alternative given all

the pricing alternatives and your farm’s individual

considerations?

Pricing Options Summary1. Do no forward pricing

2. Futures Hedge (lock in the futures price)

3. Options Hedges– Long cash grain and buy Puts (floor price, no ceiling)

– Sell cash grain and buy OTM Calls (floor price, no ceiling) (called a synthetic put)

– Long cash grain and sell Calls (Ceiling price, limited downside protection)

– Long cash grain and Fence by buying Puts and selling Calls (establishes a floor and ceiling price at a low costs)

Readings for Feb 5th: Cash Markets• In “Understanding Basis”

– p. 1-12 (read more if interested)

• Under “Pricing Strategies” you’ll find “Offering Farmers Cash Contracts”– p. 4-11 and p. 16-20

– If your photocopy is too dark, you can read this document on the course website:

www.agecon.purdue.edu/extension/programs/

grain_marketing.asp

Assignments

1. Options exercise completed

2. For the options strike prices you are interested in, watch how the premium changes each day as the underlying futures contract changes

• How does the minimum price change with changes in the premium?

Questions

• To email in questions, either give them to your host or send them to Corinne Alexander:

• [email protected]

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

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