Aplications Using Options

7/24/2019 Aplications Using Options

1/50

gricultural

conomics Rpt No.

200

Commercial

nd

Producer

Applications

Using

Options

on

rain

Futures

by

John

P Satrom

Alfred K

Chan

William

W Wilson

Department

of

gricultural

Economics

gricultural

Experiment

Station

North Dakota

State

University

Fargo

North Dakota

581 5

May

198


2/50

i hli hts

Trading

of

options on agricultural

commodity futures began

on

an

experimental basis in

ctober 1984. This report

provides

a

brief

descrip-

tion on use of

options by

merchants

and

producers. The

advantage

of using

options is

their ability to

lock

in a

floor or ceiling

price for the

underlying

future allowing the

merchant

or

producer to

take

advantage

of

favorable

price

movements.

To do so the he ger

pays premium.

n

this

sense

options

are analogous

to price insurance whereby

a

premium is

paid

to

protect against an

adverse

movement in

prices.

Options can be viewed

as

an innovation

or new

technology in he

marketing system.

They

can

be

used for a

multitude

of purposes including

hedging

long and short cash positions forward contracting s well as

speculating.

n

many cases options are

more appropriate

hedging vehicles

when

quantity

or yield

risk

is present.

Mechanics and examples of each

of

these applications

are

presented in this

publication.


3/50

TABLE

OF

CONTENTS

Page

List

of

Tables

.

.

.

ii

List of

Examples

.

. .

ii

List of

Figures

.

.

.

.

Commodity

Options:

Introduction

1

History

.

1

Definitions

.

2

Simple

Mechanics

of Option

Trading

.

3

Buying

Puts

.

4

Buying

Calls

.

4

Selling

Puts

.

.

5

Selling

Calls

.

5

Summary

on

Use of

Options

Versus

Futures

.

6

Application

of Options

by Merchants

8

Long

Cash

.

. .

.

8

Long

Cash/Long

Puts

.

9

Long

Cash/Short

Calls

.

. 10

Summary

of

Long

Cash Position

..

11

Short

Cash

.

11

Short

Cash/Long

Calls

.

13

Short

Cash/Short

Puts

.

14

Summary

of

Short

Cash

Position

.

15

Forward

Contracts

with Floor

and

Ceiling

Prices

.

17

Forward

Contracts

with

Floor

Prices

.

17

Forward

Contracts

with

Ceiling

Prices

.

19

Summary

of

Forward

Contracts

.

. 21

Quantity

Risk

. 22

Overnight Transactions

.

.

.

22

Summary

of

Quantity

Risk

.

. 25

Selected

Decisions

to

be

Made

in he

Use of

Options

.

26

Terminating

Option

Positions

.

. 26

In the Money

Vs.

Out of the Money

Options

.

27

Long

Cash/Long

Puts

.

...

...

.

27

Short

Cash/Long

Calls

.

.

30

Summary

of

Options

31

Pricing

of Commodity

Options

.

.

.

33

Concept

.

...........

Length

of Time

.

...........

33

Market Volatility

.

34

Interest

Rates

. 36

Relationships

Between

Market

and Strike

Price

.

.

36

Black Scholes

Pricing

Model

.

........

38

Delta

Factor

.

.. 41

Recent

Premiums

.

. . 41

Summary

.

.....

Selected Bibliography


4/50

List

of

Tables

Table

No.

Pag

1

MERCHANT

CASH

POSITIONS

AND

USE OF

FUTURES

AND OPTIONS

7

2

OUT OME

OF

A

CH NGE

N

FUTURES

PRICES

O

LONG

ITM ND

OTM

POSITIONS

..

. .

.

............

.

....

.

3

3

OPTION

PREMIUMS

FOR

VARIABLE

MATURITIES

.

34

4

OPTION

PREMIUMS

FOR

DIFFERENT

LEVELS

OF

MARKET

VOLATILITY

.

36

5

OPTION

PREMIUMS

FOR

VARIABLE

INTEREST

RATE

37

6 OPTION

PREMIUMS

FOR

VARIABLE

STRIKE

PRICE

37

7

INTRINSIC

AND

EXTRINSIC

VALVE

FOR DIFFERENT

STRIKE

PRICES

OF

CALL

OPTIONS

38

8

OPTION

PREMIUMS

AND

DELTA

COMPUTED

FROM

BLACK/SCHOLES

MODEL

.

40

9

FUTURES

AND

OPTION

PRICES:

MINNEAPOLIS

WHEAT

AND

CHICAGO

SOYBEANS,

NOVEMBER

1984

TO FEBRUARY

1985

.

42

List

of

Examples

Example

No.

Page

1

LONG

CASH/LONG

PUTS

.....

.

.

10

2 LONG

CASH/SHORT

CALLS

12

3 SHORT

CASH/LONG

CALLS

14

4 SHORT

CASH/SHORT

PUTS

.

.

6

5 DERIVATION

OF

FORWARD

CONTRACTS I.E.,

PRODUCERS WITH

PRICE

FLOOR

.

. .

..

18

6

DERIVATION OF

FORWARD

CONTRACTS FOR SALE

E.G.,

TO IMPORTERS

WITH

PRICE CEILING

.

.

20

7

OVERNIGHT SALE

TRANSACTION

.

23

8 OVERNIGHT

PURCHASE

TRANSACTION

.

..

24

ii


5/50

COMMERCIAL

ND

PRODUCER

APPLICATIONS

USING

OPTIONS

ON GRAIN

FUTURES

John

Satrom,

Alfred

Chan,

and William

Wilson

Commodity

Options:

Introduction

History

Commodity

options

have

had

a history

of adversity

and

diversity.

Grain

options

began

trading

on

the Chicago

Board

of Trade

as

early

as

the

Civil

War.

Shortly

after

their

introduction,

however,

the Board

of

Trade

tried

to cease

trading

because

of perceived

abuses.

The

state

of Illinois

banned

option

trading

both

on

and

off

exchanges,

but

trading

continued

despite

this

statutory

ban.

Further

restrictions

came

in

887

when

the

Board

of Trade

found

it

ecessary

to

restrict

option

trading

y its

members. Agricultural options

were then

alternately traded

and banned

between

1887

and

1936.

In 936,

Congress

banned

the trading

of

agricultural

options

completely

with

the

Commodity

Exchange

Act

of

1936.

number

of

factors

caused

the

1936

ban,

including

the following:

options

were

not

being

used

for

traditional

risk-shifting

purposes,

small

traders

lured

into

options

markets

to speculate

usually

lost money,

large

traders

could

use

options

to cause

artificial

price

movements,

terms

and

conditions

of

options

were

not

standardized,

and

congestion

near

the

close

of

the

market

could

occur

because

many

options

were

good

for

less

than

a

day

(Horner

and

Moriority

1983).

specific

case

occurred

in

he early

1930s when

options

were blamed

for

the excessive

price

movements

in

heat,

which

led

to

the collapse

of

the Chicago

Board

of

Trade's

wheat

market

in

1933.

Trouble

continued

to occur

in

he

late 1960s

and early

1970s

when

gold

options

were

being

sold

fraudulently.

The

problems

all

seemed

to stem

from

the

lack of

one

specific

governing

body.

After

the gold

incident,

the

Commodity

Futures

Trading

Commission

(CFTC)

was

given

full

control

of

all commodity

futures

and

options

trading.

The

commission

has worked

to

develop

regulations

for

exchange-traded

options,

and in

eptember

1981

the CFTC

approved

a

three-

year

pilot

program

including

options

trading

in

old,

treasury

bonds,

and

sugar.

Following

this,

the

Futures

Trading

Act

of

1982

lifted

the 1936

ban

on agricultural

options.

The result

was

development

of an experimental

three-year

program

of organized

trading

in selected

agricultural

options

which was introduced

in

October 1984.

Satrom

and

Chan

are

graduate

research

assistants

and

Wilson

is

associate

professor,

Department

of

Agricultural

Economics,

North

Dakota

State

University,

Fargo.


6/50


7/50

3

Out-of-the-

Money

Intrinsic

Value

Time

or

Extrinsic

Value

Expiration

Date

Breakeven

Level

call

(put)

is

ut-of-the-money

if ts

strike

price

is

above

(below)

the

current

price

of

the

underlying

futures

contract.

The

option,

call

or

put,

has

no

intrinsic

value.

component

of the

option

premium

which

is easured

in

a

dollar

amount

if ny)

by

which

the

current

market

price

of the

underlying

futures

contract

is bove

the

strike

price for

the

call option

and below

the strike

price

for

the

put option.

Both

at-the-money

and

out-of-the-money

options

have

no

intrinsic

value.

Another

component

of

an

option

premium,

measured

by

the

amount

by

which

the

premium

exceeds

the

intrinsic

value

of the

option

Time

Value

=

Premium

Intrinsic Value

The date

that

is

he

last

day

that

a

holder of

a

put or

call

option

may

exercise

his

or her

right

to buy

or

sell

the underlying

futures

contract

at

the option

strike

price.

After

the

expiration

date,

the option

contract

becomes

null

and void.

The

expiration

dates

will

parallel

futures

contract

months.

For

example,

a

September

spring

wheat

option

on a September

spring

wheat

futures

contract

will

expire at

least

ten days

prior

to

the

first

notice day

of

the

September

futures

contract.

There is

a separate

breakeven

level

for both

call and

put options.

For

the

call

option,

the breakeven

level

equals

the strike price

plus

the premium.

For

the put

option,

the breakeven

level

equals

the

strike

price

minus

the premium.

Simple Mechanics

of Option

Trading

Merchandisers

and, to

a

lesser

extent,

producers

are familiar

with

the advantages

of hedging

with

commodity

futures.

The development

of

options

will

in

ome cases

complement

and

in

thers substitute

for

futures

hedges,

depending

on

the individual's

risk

aversion

and potential

return.

The primary

difference

between

options

and futures

for

hedging

purposes

deals with

the price

that

is locked

in.

A futures

hedge

allows

the hedger

to

lock in a specific price

for the futures,

while

use of

options locks in

a floor

or ceiling

price for

the

futures.

An

uncovered

cash

position

is

characterized

by

having

the potential

for

high

risk

and,

at

the

same time,

large returns.

When

a futures

position

is aken

opposite

to

the

cash posi-

tion,

the

hedger

offsets

potential

cash

market losses

but

can

also negate

any

cash

market

gain.


8/50

With the use

of

options,

losses

in

he cash market

are offset

by

gains

in

he option

market

but

gains

in

he cash

market

are not

negated by

losses

in

he futures

or options.

There

are four

basic

positions in

ption

trading:

buying

puts,

buying calls,

selling

puts,

and selling

calls.

It

should

be

noted

that

puts

do

not

offset

calls

and vice

versa;

each

is a

separate type

of

option. Each option

position

depends

on

the

user s

cash

position along

with other factors

specific

to

each merchant.

long

option

position involves

limited

risk

and potentially large

returns.

Conversely,

a short

option position,

or selling

options,

entails

potentially

large

risks

and

limited

returns.

Buying

Puts

hedger with

a long

cash position

can establish

a loor

price and be

able

to take

advantage of a price rise

by having a

long put position.

The

only cost

involved is

he

premium

paid by the

purchaser to

the seller

at

the time

the transaction

is

initiated. The following

example

will

help

illustrate this.

long

cash grain

position is aken

at a futures

price

which would realize

a

small profit. The

merchant

or

producer

is

ptimistic

about prices

in

he future, yet

he

would

like to

lock in his

price

as a

floor, resulting

in a

small

profit over

operating costs.

The appropriate

action

in he option

market would be to buy puts. This allows

the merchan-

diser to

lock

in a loor

price

equal

to

the strike

price minus

the

premium.

The basic idea

behind this plan

is hat if rices decline

further, the

option

may be exercised to

obtain

the floor price.

Exercising

the put

options involves

assuming a short

futures position at

the

strike

price

when

their

actual

value

is

ess

than the

strike price.

The difference between

the

two

prices

minus

the

premium would be

the net profit. Alternatively,

if he underlying futures price rises,

the puts will not

be

exercised;

the

effective price

will be the higher cash price minus the

premium.

Buying

Calls

long

call position

allows

a hedger to

establish a ceiling price

while being able to benefit from a

price

decline. short cash grain posi-

tion

can be

protected

by

purchasing

call options. Once again, the only

cost incurred is

he premium. number of different scenarios

can be

deve-

loped to illustrate

a short cash position; in ome

cases

price risk will

be

prevalent and in thers quantity risk may be apparent. Specific

examples

of each

will be

given later.

An

illustration of

a short

cash position

will

demonstrate the simple

mechanics of a long call

position.

For instance,

a

merchandiser

or

processor) who

has

sold cash

grain

for future delivery

but does

not

have

the

physical

commodity

on hand

is

subject to

the

risk

of a price

increase before actually

buying

or

pricing

the

grain. The

merchant could hedge in the

futures market but

would not

be

able to

benefit

if

prices declined.

Purchasing

calls

would

lock

in a

ceiling

price equal

to

the strike price, plus, if prices

increased, the

merchant

would be able to

realize

the

ceiling

price by

exercising

the

call

option. This would entail

assuming a long futures position

at the

strike

price when actual value

is

greater;

the difference between the two prices


9/50

less

the premium

will

be the

net

profit.

Conversely

if

rices

fell

the

calls

would

not be

exercised;

the effective

purchase

price

would

be the

cash

price

plus

the premium.

Selling

Puts

Long

option

contracts

are

analogous

to buying

price

insurance

with

the cost

of

the insurance

being

the

premium.

Selling

option

contracts

can

then

be thought

of as

selling

or

writing

price

insurance.

The

option

writer

or

seller

receives

a

premium

in

eturn

for issuing

the insurance.

Consequently

the

option

seller

may

be

able

to

augment

his

income

by the

amount

of

the

premium.

However

the seller

must

also

be

prepared

to face

margin

requirements

and

the possibility

of a

mandatory

futures

position

if

prices move

against

him.

merchant

with a

short

cash

or forward

position

could

sell

puts

with

the

intention

of increasing

income

by

the amount

of

the premium.

This

alternative

is ttractive

only if rice

expectations

are

bullish

or

neutral

because

if

rices

decline

the

futures position may

be assumed

at

a

loss. This

is

he

negative aspect

of selling

puts.

The level

of

gain

from such

a strategy

is ixed

while

the

amount

of

loss is

nlimited.

The

primary

decision

criteria

for

selling

puts is

he premium

value

or

the

maximum

amount

that

can be added

to income.

The basic

mechanics

of selling

puts

to

increase

income

are relatively

easy

to

understand.

The

merchant

begins with

a short

cash

position

as

mentioned

earlier.

He

is

ullish

about

the future

and

feels

that

premiums

are

high enough

to support

selling

put options.

The

merchandiser

receives

the premium

right

away

but he must

also

comply with

margin

requirements.

If prices

go up

sufficiently

the

puts

are

not

exercised

by the

buyer and

the merchant

gains

the premium.

If rices

go down

the options.may

be

exercised

and

the merchant

will

be

assigned

a

long futures

position

at the

strike

price.

In

addition

to

augmenting

income

selling

of puts

can

be used to

acquire

commodity

futures

at a price

below

the

current

market price.

This

will

occur

if

he

put

is

xercised

by the buyer;

the put writer

is

hen

obligated

to

acquire a

long futures

position.

The effective

price

paid

for

the

futures

will be the

put

strike

price

less

the premium

received.

This

type

of

strategy

may

be beneficial

to a merchant

such

as a grain

processor

whose

product

price is

ixed

and

who wants

to protect

his profit

margin.

Selling

puts

offsets

an

increase

in rain

prices

by

the amount

of

the premium

and at

the

same

time

establishes a

loor price

for the

purchase

of

the

grain should prices decline.

It

should

be

noted that

if

prices

do

decline

and the

puts are exercised

the

put writer

can

immediately

offset

his

long

futures

position

by selling futures

for the same delivery

month.

Selling

Calls

The fourth

basic

option

position

is selling

calls.

This strategy

may

be

used by

a

commercial

merchant or

producer

who

has

a long cash position.


10/50

6

A

short

call

position would be taken if e had essentially bearish or

neutral expectations

about

the

particular

grain

market.

Like

selling puts,

selling

calls gives

the

merchant

the

opportunity to increase current income

or

margins

by

the amount of the

premium.

The

scenario

under which calls may

be sold

is asically when a

merchant

has

a

long cash

position

and

expects

the

market

to be

bearish

or

neutral,

as mentioned

above. When

the merchant sells

the

calls,

the

pre-

mium

is arned. Once again, he must also face margin requirements,

including possible margin calls if

he options are

exercised

and

prices

move against

him. If owever, prices fall or

remain

at approximately

the

same

level

over

the life of the contract, the

calls

will

expire.

Consequently,

the merchandiser will be

successful

in

increasing

income by

the option

premium less

depreciation if he

physical grain was

being

stored.

If

prices

appreciate significantly

during the life of the option,

the

calls would

be exercised. This

would

result

in

he

merchant being obli-

gated

to

take a short futures position

at

the

strike

price

when they are

actually valued higher.

The difference between

these two

prices

plus the

premium would result in he net loss. If he

physical grain were being

stored,

the merchant

would also realize an appreciation

in

he

value

of

the

inventory. Thus,

a ceiling price

would be

locked in

or

the commodity.

Summary

on

Use

of Options

Versus Futures

Options and

futures are inherently

related.

This

is vident by the

fact that, like

futures, there are two

basic

option

transactions

which

can

be

initiated.

One is o purchase options

and the

other is o sell or

write

options.

The specific

direction will be

determined by the

user s main

objective.

If

e

wants

to

lock

in a

floor

or

ceiling

price,

the

appropriate

action would be

to

buy options.

The

primary

characteristic

of

this strategy is

nlimited

profit potential

with the only cost

being

the

premium.

Alternatively if is

goal is

o

increase

income,

options

can

be

sold.

However, there would be

unlimited risk of

an adverse

price move,

while the gain

would

be

limited to the

premium.

Therefore, the

risks are

greater and

the

potential return

smaller

with a

short options

hedge

rela-

tive to

a long options hedge.

Table

1 summarizes

the

characteristics

of options

versus

futures

hedges

for

producers and

merchants

with

long

and

short cash

positions.

Typically,

a long

cash

position could

be hedged

in

he

futures

market

by

selling

futures contracts.

This

requires

margin money and,

in ddition,

locks

in the sale

price so

futures prevents

the hedger

from

benefiting

from

a

price increase.

However a

long

cash

position could also

be

hedged in

the

options

market either

by purchasing puts

or selling

calls.

Buying

puts

allows

the

user

to lock in

a floor

price equal

to the strike

price

minus

the

premium. Selling calls

results in an

increase

in

income

by

the amount

of the

premium although

margin

money is

required and

unlimited risk of

a

price

decrease is

realized. In

addition

if

the

underlying futures

price

increases

so

that

the calls

are

exercised the

seller

will

be

obligated to

take

a short

futures

position at the

strike

price when

they are actually

valued higher.


11/50

T BLE

1.

MERCH NT

C SH

POSITIONS

ND

USE OF FUTURES

ND

OPTIONS

Cash Position

Traditional

Futures

Positions

Alternative Option

Positions

Long

Cash

Sell

Futures

Buy Puts

Inventory

or Forward

Purchase)

requires

margin

protects against price

decrease

cannot

benefit

from

price

increase

locks

in

floor

price

.

benefit

from price

increase

must pay

premium

no

margin

Sell

Calls

increase income

by

amount

of

premium

requires

margin

unlimited

risk

of

price

decrease

possibility

of

having

short

futures

if

exercised

Short Cash

Buys

Futures

requires margin

protects

against

price

increase

cannot benefit

from

price

decrease

locks

in ceiling

price

benefit

from

price

decrease

must pay

premium

no margin

Sell Puts

increase

income

by

amount

of

premium

requires

margin

unlimited

risk

of price

increase

possibility

of

having

long

futures

position

if

exercised

Conversely,

a

short cash

position

is raditionally

hedged

in he

futures

market

by

purchasing

futures

contracts.

Once

again,

this

locks

in

a

price

so the

hedger

is ot

able

to

benefit

from

a price

decrease,

while

Buy

Calls


12/50

also

requiring

margin

money.

Alternatively,

this

cash

position

could

be

hedged in

he

options

market by

one

of two ways:

buying

calls

or selling

puts.

Buying

calls

locks

in

a ceiling

price.

Selling

puts

increases

income

by the

premium

but requires

margin

money

and exposes

the

hedger

to

unlimited

risk

of a

price

increase.

However,

if rices

decline

signifi-

cantly

and if

he

puts

are

exercised,

the

seller

will

be

required

to take

a

long

futures position

at the

strike price

when

they are

actually

valued

lower.

Application

of Options

by Merchants

and Producers

Traditionally,

elevators,

domestic

merchants

and

exporters

have made

extensive

use

of

the

futures

market

in

edging

cash

positions.

Producers

hold

similar

cash

positions

and the same

principles

apply. The

options

market

can

be used

by any

of these

participants

as a

substitute

and/or

supplement

to the

futures

market

in

he

hedging role.

Each

of these

par-

ticipants

performs

unique

functions

in

he

grain

marketing

chain.

However,

they

are

homogeneous

in

he

sense that

they

can have

similar

cash

posi-

tions.

This allows

for

generalizations

across

merchants

and

producers

about

the type of

option position

to use for

a

specific

cash

position.

A

number

of

assumptions

are

used

in ach

of the

examples

and are listed

below.

Assumptions

used

in

ll

examples:

The

purchase

or

sale

of

an

option

will be

made

at a strike

price

which

is t-the-money.

Premiums are

based

on Black/Scholes

model

calculations

and

are

representative

for

example

purposes.

Options

contracts

are

liquidated

or

offset

in ach case

instead

of

exercising

or letting

them

expire.

There will

be no change

in he basis.

This

is

ssumed

to

demonstrate

the

mechanics

and

isolate

the

effects

of

changes

in

cash

futures

and option values.

There will

always

be some

basis

risk,

and options

do not

protect

against

basis risk.

Long

Cash

For a

erchant with

a long cash

position,

the greatest

risk

is he

price risk

associated with the sale

of

that

grain.

A producer

has similar

risk

when planting

decisions

are made.

The

only difference

between

a pro-

ducer s

and merchant s

cash position

is hat

before

harvest the

producer

also has

an element of

risk

associated

with production

i.e., yield

risk).

Both participants have

a

desire

to

protect

the

value

of

their cash market

position.

When the futures

market

is

used, a futures

price is

locked

in

thereby minimizing

risk.

However,

they

would

be unable to benefit

if

futures

prices increase

after

the

futures

position

is

taken.

This is where

an

options

contract

would

be

desirable.

As

demonstrated

in Table 1

merchants

or

producers

with

long cash

positions

can

either

buy

puts

or

sell

calls. Examples

of each

are described

below.


13/50

Long Cash/Long

Puts:

A merchant

or producer

with

a

long cash

position

who

wants

protection

against

a bearish

price

move

could

lock in

a floor

price

but

also

benefit

from

a

potential

price

rise

by purchasing

put options.

The

buyer

must

decide

whether

to buy

in-the-money

(ITM), at-the-money

(ATM),

or out-of-the-money

(OTM)

puts, although

we are

assuming

ATM

in his

case

(the

differences

will be

discussed

in

reater

detail

later).

The

premium

will

vary

for each

case

as will the

final

results.

long

put

position

gives

the

uyer

the

right

ut not

the obligation

to

sell futures

at a specified

strike

price

or

exercise the option.

However,

instead

of

either

exercising

or letting

the option

expire,

the buyer

may also offset

his

position

by selling

the

puts

back.

The

price

movement

of

the

underlying

futures price

will

affect

the

buyer s

decision.

If he

underlying

futures

price

increased

signifi-

cantly

over

the life

of

the

option,

the

buyer could

then

either

let

it xpire

and

realize the

greater price

or

sell

the

puts

back

and

possibly

earn

a

premium

plus the

higher

cash

price.

If he

opposite

occurred,

that

is

he

underlying

futures

price

dropped considerably,

the

buyer

could

again pick

one

of

two

possibil-

ities:

exercise

the

option

and be

given

a

short futures

position

at

the

strike price,

or offset

the

option,

receive

a

premium,

and

be out

of the

futures

market completely.

In ither case,

the

risk is

limited

to the

premium paid

while

the

possible

returns

are

unlimited.

The

mechanics

of this

type

of transaction

are best

illustrated

in

Example

1.

Example

illustrates

that

the

largest net

result occurs

when the

underlying

futures

price

increases It

hould

e

noted

that

the

premium

earned

on the liquidation

of

the puts

is qual

to

zero

because

there

is

o

intrinsic

or extrinsic

value left

in

he

option.

Conversely,

when the

underlying futures

price

declines,

the intrinsic

value

of

the

puts increases

and results

in

he greater

premium being

earned from

offsetting

the position.

However, the net

result

is

still a negative

figure

because the

intrinsic

value did

not increase

enough

to

cover both the

cash

loss

and

the

original

premium.

Thus,

the returns

have

unlimited

upside potential

while the

largest

loss is

limited

to the

premium.

A traditional

hedge against

a

long

cash position

would

be

to sell

futures.

In

Example

1

because

the

basis

is

assumed unchanged

the

net

result

would

be zero

and the effective

sales

price would be

410.

Thus

if

prices increase

an options

position

is preferable

to

a

futures

hedge

and vice

versa

for price decreases.


14/50

-

1

-

EXAMPLE

1 LONG CASH LONG

PUTS

Setting:

September

3

984

Buy 20,000 Bushels

@410

December

Futures

380?

Duluth

Basis

30O

December 380

Put

8?

A.

ell cash

on November

1 at which

time

December

futures

increased

to 4209.

Basis

is

nchanged

at

30 .

1. ell

offset)

put, or let expire

2.

Calculation

of

returns

Return from

cash sale 450?

Less purchase price

-410

Less

premium

paid

- 8

Plus premium earned

0

Net

Result

9

Effective

Sale

Price

442?

B.

ell cash

on

November

1 at

which

time

December

futures

decreased

to 350.

Basis

is

nchanged

at

+30.)

1.

Could

exercise

option,

or

sell

offset)

put

2. Calculation

of returns

Return

from cash sale

380?

Less purchase

price

-410

Less

premium

paid

-

8

Plus

premium earned

30

Net

Result

- 8

Effective Sale Price

402?

Long Cash/Short Calls:

Another

tactic

for

a

merchant or producer

with a long cash

position

is to sell

call options

A short call

position

allows the

seller

to

augment

current

income

by the

amount

of

the premium This

course

of

action is

especially

attractive

if

prices are

expected

to remain

relatively

stable


15/50

Once

again,

the

ITM, ATM,

or OTM

calls

can be

sold,

but it

is

assumed

that

ATM

calls

are

used.

In

his

case,

the

seller

receives

the

premium

at

the

time

of

the sale.

The return

is

imited

to

this

premium

while

potential

losses

are

unlimited.

Margin

money is

lso

required

to

cover

a potential

futures

position.

short

call

posi-

tion

does

not offer

the

seller

many

alternatives

in egard

to

a

price

increase

or decrease.

The

only

choice

is

etween

holding

the

call

position

with the results

determined

by the actions

of

the

buyer

or

buying

the

calls

back

before

they

are exercised

or expire.

If

he

underlying

futures

price

increases,

the

buyer

may

exercise

the calls,

in

hich

case

the

seller

will

be

given

a

short

futures

position

or

the

seller

can

offset

the

calls

before

they

are

exercised

to

ensure

staying

out

of the

futures

market.

However,

the

seller

must

remember

that

if

e offsets

the options,

he will have

to pay

a premium.

If

the opposite

occurs

where

futures

prices

decrease,

the buyer

will

most

likely

not exercise

the calls

because

the

price

move

is

favorable.

The

seller

can

then

buy

the

options

back

any

time

before

expiration

if esired,

or he

could

simply

let them

expire

without

liquidating.

Example

illustrates

the mechanics

of

this

type

of

transaction

when the

options

are

offset.

It

is

vident

from this

example

that

the greatest

possible

net return

is limited

to

the premium

earned

from

the

call

sale,

which

in

his

case

is

8 cents.

Furthermore,

the seller s

risk is

heoretically

unlimited.

When

the futures

price

did decline

and

the calls

were

offset,

the premium

paid

was

equal

to zero

because

the option

had no

intrinsic

or extrinsic

value

left.

However,

in

art A

where

the

futures

price

increased,

the

options

gained

intrinsic

value

and thus

resulted

in

he 40-cent

premium

paid

for

offsetting

the calls.

Therefore,

selling

call

options with

the

intention

of

later

liquidating

this

position

is isky

and

is eneficial

only when

futures

prices

remain

relatively

stable

or

increase.

Summary

of Long

Cash Position

A merchant

or producer

with a

long cash

position

has two option

alternatives:

to buy

puts

to

lock ina

floor price,

or

to sell calls

to

supplement

current

income.

An

important

difference

between

the

two choices

is

he risk

levels

involved.

Buying

puts

is

referable

to traditional

hedging

if

utures

prices

increase

because

the gain

in

ash prices

is

ot

offset

by losses

in

he futures.

long

put position

results

in

imited

risk

and

unlimited

profit potential,

while

a short

call

position

is

harac-

terized

by a

return

limited

to

the premium

and

risk that is

heoretically

unlimited. Thus

in

most hedging applications buying puts

will be

more

advantageous

than selling

calls.

Short

Cash

Another

typical position

of

grain merchants

processors

and

to

a

lesser

extent

producers

is

to be

short

cash

grain.

If

a

futures

market

is used as

a

hedge

the purchase

price

is locked

in

so

long

as

the

basis

is


16/50

-

12

-

EXAMPLE

2

LONG

CASH/SHORT

CALL

Setting:

September

3 1984

Buy 20 000

Bushels @410

December Futures

8 ?

Basis

3

December 380

Call 8?

A

Sell cash on November 1 at

which time

December futures increased

to 420.

(Basis is

unchanged

at +30 .)

1

Buyer

may exercise calls,

or seller may offset

(buy

back)

the call

2. Calculation of

returns

Return from cash sale 450?

Less

purchase

price

410

Option premium

earned

8

Less premium

paid -

40

Net Result

8?

Effective Sales

Price

418?

*Loss in ption

is

ffset by gain

in

ash

value.

B

ell

cash

on

November

1

at

which time

December futures decreased

to

350.

(Basis is nchanged at +309.)

1 ption will

not

be

exercised y purchaser

2 Calculation

of returns

Return from

cash sale

380?

Less

purchase

price

-410

ption

premium earned

8

Less premium paid

0

Net Result - 22?

Effective Sales Price 388?

unchanged.

However the merchant

is

unable

to take advantage

of

a decrease

in prices

after

the

contract

is

made.

An options hedge

on

the

other hand

permits

the buyer to benefit

from

a price

decline.


17/50

3

A merchandiser

with

a

short

cash

position

would

ultimately

like

to

establish

a ceiling

price

and take

advantage

of a

fall

in

rices.

A common

scenario

is or

a

erchant

or

processor

to sell

grain

for some

future

month

but

not

have

the physical

grain

on hand.

Purchasing

call options

would

establish

a ceiling

price

for

the

eventual

cash

purchase.

Merchants

can

either

buy

calls

or

sell

puts

against

a

short

cash

position.

The

following

examples

illustrate

the

mechanics

involved

and

possible outcomes.

Like

the

first

examples

the same

assumptions

apply.

Short

Cash/Long

Calls:

A merchant

or producer

with

a short

cash

position

who

wants

to pro-

tect against

a bullish

price

move

and benefit

from

a

potential

price

decline

could

lock in

a ceiling

price

by purchasing

call options.

It

is

ssumed

that

ATM calls

are

bought

although

ITM

or OTM calls

are

also possible.

The

buyer

pays

a premium

for

the

privilege

to lock

in

the ceiling

price.

The

long call

position

gives

the

buyer

the

right but

not

the

obligation

to buy

futures

at the

strike

price

or

to

exercise

the

call

option.

Two

more

alternatives

still

exist:

he

could

let the

options

expire

or

offset

his position

by selling

the

calls back.

The

decision

depends

on

the

movement

of the

underlying

futures

price.

If he

underlying

futures

price

increased

significantly

the

merchant

could

exercise

the options

in

hich case

he would

receive

a long

futures

position

at

the strike

price

when

the futures

value

is

actually

greater.

Alternatively

the

buyer

could

liquidate

his

option position

gain

a

premium

and

be clear

of the futures

market.

If

he

futures price

declined substantially

the

buyer could either

let

it

xpire

and

realize

the lower

price

or offset

the

calls to

possibly.gain

a

premium.

Furthermore

because

the futures

price

declined

the

purchase

price

will also

be

less.

Example

illustrates

the

mechanics

of

this

type

of transaction.

This example

shows that

the greatest

loss

is imited

to the

premium

paid

while

the

potential

returns

are

virtually

unlimited.

When

the

underlying

futures

price increased

the

net result

was

a loss

of 8

cents--the

premium. The

premium

earned

from the

liquidation

of the

calls just

offset

the larger

purchase

price

because the intrinsic

value of the

calls had

increased.

Conversely

in

art B the premium

earned

equalled zero

because there

was

no intrinsic

or extrinsic

value

left.

The net result

is

greater

in Part

B

because of

the

lower

purchase

price.

Buying

calls

is

preferable

to traditional

hedging

if

futures

prices

decrease because

the

gain

in

the

cash price

is not

offset

by losses

in the

futures.

If

futures

prices

increase

buying futures

yields

a

greater

return by

the cost

of

the premium.


18/50

-

4

-

EXAMPLE 3.

SHORT

CASH LONG

CALLS

Setting:

September 3

1984

Sell

20 000 Bushels @410

December

Futures

380?

Basis

3

December

380

Call

8?

A

Buy cash

on

November

1 at

which time

December futures

increased

to

420 .

1

ption

can be

exercised,

or sold

to

offset

2

Calculation

of returns

Return

from

cash

sale 410?

Less purchase

price

-450

Less

premium

paid

-

8

Plus

premium

earned

40

Net Result

-

8?

Effective

Purhcase

Price 418?

B

Buy

cash on

November

1 at

which

time December

futures

decreased

to

350 .

1 Option

could

be left

to

expire,

or

offset

2 Calculation

of returns

Return

from

cash

sale

410o

Less

purchase

price

-380

Less

premium

paid

-

8

Plus premium

earned

0

Net Result

22

Effective

Purchase

Price

388?

Short

Cash/Short

Puts:

Buying

call

options

is

ot the

only

strategy

for

a

erchant

or pro-

ducer

with a

short

cash

position.

Put

options

could

also

be sold.

This

alternative

does

not lock

in

a

ceiling

price

however.

Instead

it

either

offers

a

chance

for

the

merchant

to

increase

his current

income

or buy

futures

at a

lower

price

if

the

options

are

exercised.

The

best

outcome

will

occur if

the

market

remains

relatively

stable


19/50

5

so

that

the options

will not

be exercised,

but

yet

retain some

intrinsic

value.

Furthermore,

the results

will vary

depending

on

whether the

merchant

sells

ITM, ATM,

or

OTM puts;

however, ATM

puts

will

be

assumed

sold.

Selling puts

will

produce

a

limited return

equal

to

the

premium

while the risk

potential

will

be

unlimited.

In

addition,

the

merchant

will

be

required

to have

margin

money

available.

Overall,

a short put position

has

virtually

the same

fundamental

characteristics

as a short

call position.

The

seller

can

only choose

between

liquidating

his position

before the

puts

are

exercised

or

waiting

for the buyer s

actions.

If he

underlying

futures

price

increases,

the buyer

would likely

let the

options expire

because

he

wants

the highest

possible

price. The seller

then

can decide.whether

buying

the

puts

back

or

letting

them expire

will result

in igher

returns.

If he

futures price

decreases, the buyer

would probably

exercise

the

puts,

resulting in he

seller s

assuming a long

futures

position at

the strike price.

However, the

seller could

also buy

the

puts back

before they

are exercised

to

alleviate

entering the

futures

market.

The

procedures

and

outcomes

involved

in a

short

cash/short

put position when

the futures

price increases

and

decreases

are

illustrated in

xample 4 The option position

will be

offset

in oth

instances

to insure consistency

with

previous

examples.

Part

B

of Example 4 shows

that

a

positive

return occurs

when the

underlying

futures price decreases,

and

this

return

is qual

to the

premium

of

8

cents. The merchant

paid 30

cents to buy the puts back

because of

the

gain

in ntrinsic

value. In

ontrast, the

cost of

liquidating

the

short put position

in art A

was

risky

because the

option had

no

intrinsic

or extrinsic value remaining.

It is bvious

that

the reason

the net

result was negative

in art A was

because of

the

greater

cash

purchase

price.

However,

if

ptions

had not been

used at

all,

the

net

result

would

have been

-40 cents.

Conversely,

the outcome

in

art

B

was positive

because of the smaller

cash price.

Thus,

a erchant

selling

put

options

with

the intention

of

later

buying them back accepts a theoretically unlimited

amount of

risk,

while the return

is imited to the premium.

The

premium can

only

be

realized if he futures

price remains relatively stable or

decreases,

however.

Summary of Short Cash Position

The last two

examples have shown

that

a erchant

or

producer with a

short cash position

has

two basic

option

strategies

to

choose from

depending

on his objectives.

If

his main objective

is

to

lock in a

ceiling

price on the

purchase

of

the grain call

options should

be

bought. This

tactic also permits the

merchant

to

benefit from

a

decline

in

grain prices.

Buying

call

options

is

preferable

to traditional

hedging i.e.

buying

futures

if

futures

prices subsequently

decline.

If the

main goal

is

to

augment current

income

or margins

and

prices

are

expected

to be

relatively

neutral

or

slightly bearish

put options


20/50

6

EXAMPLE 4. SHORT

CASH/SHORT PUTS

Setting: September 3

1984

Sell

20,000 Bushels

@410

December Futures

8 ?

Basis 30

December 380

Call 8?

A.

uy

cash on November 1 at

which

time December futures

increased

to 420 .

1. ption could be

left

to

expire, or

offset

by

seller

2. Calculation

of returns

Return from cash sale

410?

Less purchase

price

-450

Premium

received

8

(Sept. 1

Less

purchase

of

put

0

Net Result

32

Effective Purchase Price

442?

B. uy

cash

on November

1 at which

time December futures

decreased

to

350

1. Buyer

may

exercise

option, or

seller may

offset (buy

back)

2. Calculation

of returns

Return

from

cash sale

410?

Less purchase

price

-380

Premium

received

8

Less

purchase

of

put 30

Net Result 8?

Effective Purchase

Price 402?

should

be

sold.

The disadvantage

of

this procedure

is hat

if rices

decrease

and the

options

are

exercised before

they are

offset,

the seller

will

be

required

to take a long

futures position

at

the strike

price

when

the actual

value

is less.

Again, the

greatest

difference

between

buying

calls

and

selling

puts is the

risk level

involved.

Purchasing

calls

results

in a limited

risk the

premium)

and

unlimited returns.

Selling

puts,

on the other

hand,

is

characterized

by

theoretically

unlimited

risk,

with only

limited

returns

the

premium).


21/50

7

Forward

Contracts

With

Floor

and

Ceiling

Prices

The

options

market

has

the

possibility

of

giving

a new

dimension

to

forward

contracts.

Typically,

forward

contracts

have

been

made

by

elevators

to producers,

by exporters

to importers

and

by merchants

to

processors.

In

he past,

these

types

of

contracts

have

been

implemented

via the

futures market.

The

result

has been

a

forward contract

with

a

fixed

price.

The disadvantage

of

this

situation

is

hat

a

producer

would

be unable

to benefit

from

a rise

in rices

or an

importer

unable

to

take

advantage

of

a

fall

in

rices.

Agricultural

options

stand

to change

this

scenario

by making

forward

contracts

more attractive

to producers

and end

users.

Merchants

can

offer

a

forward

contract

with

a

floor

or ceiling

price

by

incorporating

the

use

of options.

The logic

behind

this

plan

is

asy

to

understand

because

it

ollows

from

previous

examples.

For

instance,

an

elevator

can

lock

in a

floor

price

for

its

own grain

sale

by purchasing

put

options

and then

pass

this

floor price

on

to producers

through

a forward

contract.

The cost

of the

put

options,

or the premium,

would

be included

in

alculating

the

producer s floor

price.

Likewise,

a

erchant

can lock

in a

ceiling

price

on

purchases

by buying

call options,

which can

then be

passed

on

to end users

via

a orward

contract.

Once

again,

the

ceiling

price

would

reflect

the

exporter s

cost

of

buying

the calls.

The

mechanics

of

these

transactions

will be

demonstrated

later.

A

number

of advantages

to both

merchants

and their

customers

can

be

realized

by incorporating

options

into

forward

contracts.

The biggest

advantage

to

producers

and

end

users

is hat they

could

lock in

a floor

or

ceiling

price

and

would

be able to

benefit

from a

favorable

cash

price

move;

with

traditional

forward

contracts

they

would

not. Furthermore,

the

new

forward

contract

would

permit

individuals

to take

advantage

of options

indirectly through

the

merchant without

being

directly

involved

in

he

option market

or

understanding

the mechanics

themselves.

Merchants

will

benefit

from

this

new concept

as long as

their

customers

make

use

of the

program.

This is

vident

because

the merchant s

return

is ependent

on

throughput.

Consequently,

one of

the most

important

advantages

of a for-

ward

contract based

on options

is hat

it ffers

another

merchandising

alternative

and

could

stimulate

additional

grain

handled.

Specific

examples

of

forward

contracts with

floor

and

ceiling prices

are given

below:

Forward

Contracts

with

Floor

Prices:

Forward

purchase

contracts

have typically

been

made

at

fixed

prices.

One

of

the

most

common transactions

with

this

type

of

contract

is

between

an elevator

and a producer.

If the elevator

is doing

a good

job

of

marketing through

the futures market and

reflects

this

in

its

forward

contracts

the producer

need not become directly

involved

in

the

futures

market.

Part A

of Example

illustrates

how an elevator

calculates

the

traditional forward

contract

price and

hedges in the

futures

market.


22/50

-

18

-

EXAMPLE

5.

DERIVATION OF FORWARD

PRODUCERS) WITH PRICE FLOOR

CONTRACTS

FOR

PURCHASE

(I.E., TO

Setting:

September

3,

984

December Futures

Basis (Terminal Market)

Trans.

and

Handling

December

380

Put

38 9

9

9

A.

Derivation

of conventional

forward contract

price:

selling December

futures

Calculation:

December

futures

3809

Basis

+30

Trans. and

handling

-50

Producer Price

3609

Hedge

by

B.

Derivation

of forward

contract

prices

options

Calculation:

Strike

Price

Basis

Trans.

and handling

Less put premium

Producer Price

1. If

a

b

with price floor

380O

30

-50

-8

35 9

December

futures increase to 420

by

November

1

Option

will

not be

exercised

but

will be offset

Derivation

of producer

price:

December

futures

Basis

Trans.

and

handling

Less

option

premium

(Sept.

3

Plus

option value

(Nov. 1

Producer Price

4 9

30

50

8

0

392

December

futures

decrease to 350 by

November 1

Option

can be

exercise,

or

offset

Derivation

of producer

price:

December futures

3509

Basis

30

Trans.

and

handling

-50

ess option

premium

- 8

Sept. 3

Plus option premium

Nov. 1

Producer Price

30

352?

Buy put

2. If

a

b

_ __


23/50

9

This type

of contract

allows

the

producer

to

lock

in a

sale

price

of

3.60.

The

disadvantage

of

this

contract

is hat

the

producer

cannot

benefit

from

a

rise

in

rices.

The use

of

options

will

alleviate

this problem.

forward

contract

with

a

floor

price

can

be

offered

if

he

merchant

incorporates

put

options

into the

scheme. Part

B

of

Example shows

how this

floor

price

is

erived

and

the

consequences

of

a

change

in

the

underlying

futures

price

over

time.

It

hould

be

noted

in

he

following

examples

that,

once

again,

the option

positions

are

assumed

to be offset.

In his

example,

the

merchant

purchased

at-the-money

put

options

at

a

premium

of 8

cents.

It

is

emonstrated

that

the floor

price

quoted

to the

farmer

is

ess than

the

flat

forward

contract

price

by

the

amount

of this

premium.

Thus,

the

put

premium

will affect

the

attractiveness

of

the

price

floor

contract.

f the

underlying

futures

price increased

over

the

life

of the

contract,

the

merchant

could

either

let the

option

expire

or

liquidate

his

position.

It

is

ssumed

the

position

is iquidated;

however,

there is

o

intrinsic

or extrinsic

value

left

in he

option

so the

merchant does

not receive

a

premium

on the

sale.

The

merchant

does

realize

the greater

future price,

which

is assed

on

to

the pro-

ducer.

Consequently,

the

producer

received

3.92 with

the

price

floor

contract rather

than

3.60

under

the

conventional

forward

contract.

If he futures

price

decreased,

the

merchant

could

have

exercised

or

offset

the

option.

Once again,

it

is

ffset.

The

merchant

does

receive

a

premium of 30

cents

on the sale

in his

case,

because

the

option

has

gained intrinsic value.

However,

this

is

iscounted

by

the

futures

price

decline. The

end result

is hat

the producer

realized

the

floor

price.

Forward

Contracts

With

Ceiling

Prices:

Traditionally

domestic and

export

merchants have

offered forward

sales

contracts

at

fixed

prices. The

futures

market is

n important

component

in

etermining

the specific

price.

Part

A

of

Example

6

demonstrates

how

the conventional

forward

price is

erived

and the

appropriate futures position taken.

This

type

of

contract

is

appealing

to buyers, such

as importers,

if

hey can establish

prices

for deferred delivery.

However

by doing so,

they

do not benefit

from

price

reductions.

Options

give

merchants

the opportunity

to change

the

typical forward

contract.

A

merchant

could offer

a forward

sale

contract

with

a

ceiling

price by purchasing

call

options.

The

mechanics

are iden-

tical to

the earlier example

of

a

merchant

with a

short

cash

posi-

tion.

By

purchasing

calls

the

merchant

locks in a ceiling

price

and

can

pass

this

on to

his

customers

via a

forward

contract.

The

only


24/50

2

EXAMPLE

6. DERIVATION

OF

FORWARD CONTRACTS

FOR SALE

(E.G.,

TO

IMPORTERS)

WITH PRICE CEILING

Setting:

September

3, 984

December

Futures

3809

Basis (Terminal

Market)

30O

Trans. and Handling

50O

December

380

Put

A. Derivation

of

conventional forward contract

price: Hedge

by

buying

December futures

Calculation:

December

futures 380O

Basis +30

Trans.

and

handling

+50

Offer

Price

460

B. Derivation

of

forward

prices

with

price

ceiling:

uy

call

options

Calculation:

Strike

price

3809

Basis

30

Trans. and handling +50

Less

put

premium + 8

Offer

Price

468

1. If ecember

futures increase to 420

by November 1

a

Option

can

be

exercised or offset

b

Derivation of

importer price:

December

futures

420

Basis

30

Trans. and handling

+50

Plus

option

premium + 8

(Sept. 3

Less option

value

-40

(Nov. 1

Effective Purchase

Price

468

2. If ecember futures decrease

to

350

by

November 1

a ption will not be

exercised, but is ffset

b Derivation

of importer price:

December futures 3509

Basis

30

Trans

and handling

+50

Plus

option premium

+ 8

Sept.

3

Less option

premium 0

Nov.

1

ffective

Purchase

Price 438B


25/50

2

stipulation

is

hat

the cost

of the calls

is

lso

passed

on

to

the

customer,

built

in

o the

ceiling

price.

Importers,

as

well

as other

end

users,

should

find

this

contract

more

appealing

because

they

can

still

take

advantage

of

a price

decline,

and

it

llows

them to bene-

fit

from

options

without

actually

trading

them.

The

calculation

of

the forward

ceiling price

is emonstrated

in

Part

B

of Example

along

with

the results

of

an

increase

and

decrease

in

he underlying

futures

price.

The merchant

bought

at-

the-money

call

options

for

a premium

of 8

cents.

The ceiling

price

is

hen

greater

than

the

flat

price

by

the amount

of

this

premium.

If he

underlying

futures

price

increases,

the merchant

has

two

alternatives:

exercise

or

offset

the

option.

For

the sake

of con-

sistency

it is gain

assumed

that

the calls

are

liquidated.

The

increase

in

he

underlying

futures

price

results

in a gain

in

he

option s

intrinsic

value,

which

is eflected

in he

40-cent

premium

earned

on

the

call

sale.

This

premium

offsets

the

rise

in

he

futures

price

and

is

assed

on to the

importer.

Consequently,

the

price

realized

by the

importer

is

qual

to

the

ceiling

price origi-

nally

quoted

to

him.

If instead

the futures

price decreases,

the merchant

again

has

two

possibilities:

to

let

the option

expire

or

offset

his position;

the

latter

was chosen

here.

The

option s

value drops

to

zero

because

of

the

decline

in

he futures

price

so no premium

was

recovered

on the

liquidation.

However,

because

of

the

flexibility

of

options, the

merchant is ble

to

pass

the lower

futures price

on

to the buyer.

Thus,

the

buyer must

decide

if

ocking

in a

ceiling

price that

is

greater

than a flat

forward

price

is

orth

the

benefits

received.

The

conventional

forward

contract

is

ore

beneficial

if rices

do

rise,

but isa riskier

alternative.

Summary

of Forward

Contracts

A forward

contract

with

a floor

or ceiling

price

built-in

is a

new

marketing

concept,

the

success

of

which

depends

on

the conceptual

understanding

by

merchants,

the premium

values, and

effective

prices

relative

to farm programs

prices.

Country

merchants

can offer

producers

an

array of

marketing

alternatives

ranging

from fixed

price

to various

floor

price

contracts. Similarly,

merchants could

offer

end

users

an array

of

marketing

alternatives

ranging

from

fixed price

to various

ceiling

price

contracts.

The

primary advantage

of

incorporating

options

into forward

contracts

is

that both

the

customer

and

the

merchant

can lock

in a

floor

or

ceiling

price, which

not

only allows

the customer

to

benefit from

options

without

direct involvement

in

the options

market

but

also could attract

business

for the merchant.

There are

additional types

of marketing

situations

in

which merchants

may incorporate

options,

but the

fundamental

positions

will

be

similar.

Specifically,

traditional

forward

contracts

have

characteristics

similar

to no-price-established

NPE) and

basis

contracts

although

the latter

have ulterior

advantages.

Thus, options

may

also prove

useful

in

augmenting

other

conventional

marketing

plans.


26/50

Quantity

Risk

Another

viable

use

of

options

is

o hedge

against

quantity

risk.

Many

merchants

make

cash

transactions

after

the

futures

exchanges

have

closed

and

when the

exact

quantity

is

nknown.

Consequently,

there

is isk

between

the

cash

transaction

price

and the

next

day's

price

when

the

hedge

is laced.

A solution

to this

problem

would

be

to buy

options.

Another

type

of

quantity

risk

is

haracterized

by

a

grain

merchant's

having

ten-

dered

an offer

to sell

grain

overseas

but

not

knowing

for

several

days

whether

the

offer

will

be

accepted.

During

this

time

the price

of the

com-

modity

could

move

up

or down.

If he

exporter

had

hedged

in

he futures

market

by

purchasing

futures

and

the offer

was

rejected

after

the

price

of

the

commodity

had

fallen,

the

merchant

would

be subject

to a

loss in

he

futures

market.

By

purchasing

call

options

instead,

the

exporter

would

have

ensured

that

if he offer

was

rejected,

his

loss would

be limited

to

the

premium.

Producers

are

also

exposed

to quantity

risk

in reharvest

hedging.

Indeed,

perhaps

one

of

the

hindrances

detracting

producer

use

of

futures

for

hedging

is

uantity

or yield

risk.

As

an

alternative,

pro-

ducers

could

use

options

as a hedge,

which

in ome

cases

is

ore approriate

when

quantity

risk

exists.

The

examples

below

illustrate

the

mechanics

of the use

of

options

where quantity

risk

exists

and are

referred

to

as Overnight

Transactions.

Overnight

Transactions

Example

demonstrates

the

mechanics

of

an overnight

transaction.

The main

feature

of

this

example

is

a merchant's

making

an offer,

which remains

valid for

five

days,

to sell grain

at

$4.10

per

bushel.

To hedge

this

tender,

the

merchant

buys

at-the-money

call options

at

a

premium

of 8

cents.

The

merchant

does this

because

he

wants

to

establish

a ceiling

price

so that

if

he offer

is

ccepted

and prices

rise,

he

can

still

profit.

Likewise,

he

wants

to limit

his losses

if

the

offer

is

ejected

and

prices

fall. Whether

the

offer

is ccepted

or rejected,

however, the returns

will depend

on

the

movement

of the

underlying

futures

price.

Scenarios

are then

given

for offers

that

are

accepted

and rejected.

Part

A

of Example

illustrates

that if

he offer

is

ccepted,

the

merchant

effectively

has a short

cash/long

call

position. Therefore,

the

returns

realized

when the

underlying futures

price

increases

and

decreases

can

be calculated

using

the same mechanics

as in

revious

short

cash/long

call

examples.

Part

B shows the

effects

of

a

futures

price

increase

and

decrease

when

the

offer

is

rejected.

It is

apparent

that the greatest

return

Aplications Using Options

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Transcript of Aplications Using Options