Hedging with Option Contracts Hedging – Taking a position in the futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change in price contracts, or from an adverse change in production in yield contracts.

Basis Basis – Difference between cash market price (CP) and futures price (FP) Basis = CP – FP Use futures contract for month closest to but beyond the delivery month. Perfect hedge occurs when basis turns out as expected.

Dimensions which affect Basis Time – cost of storage, expectations Space – Availability of storage, cost of transportation Quality – Differences from contract specifications Availability and price of substitutes

Basis Studies There are repeatable patterns in the relationship between cash market price and futures price. Consequently, evaluating historical patterns in this relationship can give indications on what the Expected Basis will be.

Option Pricing: Premium = Intrinsic Value + Time Value Intrinsic value is the difference between actual price of the underlying futures contract and the strike price when the option is in-the-money. Otherwise it is zero. Time Value is the difference between the Option Premium and Intrinsic Value.

Intrinsic Value Intrinsic value is the difference between actual price of the underlying futures contract and the strike price when the option is in-the-money. Otherwise it is zero. Intrinsic Value for Calls = Current Futures Price less Strike Price if positive, otherwise zero. Intrinsic Value for Puts = Strike Price less Current Futures Price if positive, otherwise zero. In-The-Money option: An option with a positive intrinsic value At-The-Money option: An option with the strike price and the price of the underlying futures contract nearly the same. Out-Of –The-Money option: An option that would have negative value if exercised.

Time Value Time Value is the difference between the Option Premium and Intrinsic Value Time Value = Premium less Intrinsic Value. Time value is a measure of the risk premium the writer requires to write the option. Time value may be viewed similarly to the premium paid to insurance companies to insure against loss.

Short Hedge With Put Options Basis/Expected Basis/ Target Price/Actual Price Cash Futures/Options 5/1 Begin Prod. Cash 3.10/bu. 5/1 Dec Fut 3.25 Buy Dec. Put with Strike Price 3.25, Premium $0.25 10/1Expected Basis –0. 25 10/1 Fut. Hedge TP= 3.25-0.25= 3.00 10/1 Floor price = 3.25-0.25-0.25 = 2.75 10/1 Sell Cash @ 2.70/bu 10/1 Dec. Fut 2.95 Sell Dec Put @ 0.35 Actual Basis –0.25 10/1 Act. Net Price = 2.70 - 0.25 + 0.35 = 2.80 =2.80 Net from cash 2.70 Net from options +0.10 Using put options sets a floor price equal to the strike price plus expected basis less the premium paid for the put. Price was higher than the floor price because the put was sold back collecting the 10 cents time value that remained, giving a premium over the floor price even though price fell below the strike price .

Long Hedge with Call Options Basis/Expected Basis/ Target Price/Actual Price Cash Futures/Options 10/1Expected Basis –0. 25 10/1 Futures Hedge TP = 3.25-0.25= 3.00 10/1 Ceiling price = 3.25-0.25+0.25 = 3.25 5/1 Begin Feeding Cattle Cash Corn 3.10/bu. 5/1 Dec. @ 3.25 Buy Dec. Call with Strike Price 3.25, Premium $0.25 10/1 Buy Cash @ 3.25/bu 10/1 Dec. Futures 3.50 Sell Dec. Call @ 28 cents Actual Basis –0.25 10/1 Act. Net Price = =3.25 +0.25 –0.28 = 3.22 =3.25 - 0.03 = 3.22 Net paid cash 3.25 Net from options +0.03 Using call options sets a ceiling price equal to the strike price plus expected basis plus the premium paid for the put. Price was lower than the ceiling price because the futures market price was below the strike price. The premium collected when selling the option back also reduced the net price paid.

Short Hedge With Fence – Buy Put Option and Sell Call Option Basis/Expected Basis/ Target Price/Actual Price Cash Futures/Options 5/1 Begin Prod. Cash 3.10/bu. 5/1 Dec Fut 3.25 Buy Dec. Put with Strike Price 3.10, Premium $0.06 Sell Dec. Call with strike price 3.40, premium $0.05 Net Prem Paid = $0.01 10/1Expected Basis –0. 25 10/1 Floor price = 3.10-0.25-0.01 = 2.84 10/1 Ceiling price = 3.40-0.25-0.01 = 3.14 10/1 Sell Cash @ 2.70/bu 10/1 Dec. Fut 2.95 Sell Dec Put @ 0.18 Buy Dec Call @0.02: NPR=0.16 Actual Basis –0.25 10/1 Act. Net Price = 2.70 - 0.01 + 0.16 = 2.85 =2.80 Net from cash 2.70 Net from options +0.15 Buying put options and selling call options fences the potential range of price outcomes between the floor and ceiling prices. Price was higher than the floor price because the options were offset collecting the 1 cent net time value that remained in the options.

Long Hedge With Reverse Fence – Buy Call Option and Sell Put Option Basis/Expected Basis/ Target Price/Actual Price Cash Futures/Options 5/1 Need cash corn 10/1 5/1 Dec Fut 3.25 Buy Dec. Call with Strike Price 3.40, Premium $0.06 Sell Dec. Put with strike price 3.10, premium 0.05 Net Prem. Paid = $0.01 10/1Expected Basis –0. 25 10/1 Ceiling price = 3.40-0.25+0.01 = 3.16 10/1 Floor price = 3.10-0.25+0.01 = 2.86 10/1 Buy Cash @ 2.70/bu 10/1 Dec. Fut 2.95 Sell Dec Call @ 0.01 Buy Dec Put @ 0.17: NPR=0.16 Actual Basis –0.25 10/1 Act. Net Price = 2.70 + 0.01 + 0.16 = 2.87 =2.87 Net from cash 2.70 Net from options -0.17 Buying call options and selling put options fences the potential range of price outcomes between the floor and ceiling prices. Price was higher than the floor price because the options were offset paying a net 1 cent time value that remained in the options.

Important concepts to hedging with options Basis =CP - FP somewhat predictable Call Options give Ceiling price with opportunities for lower prices. CP = Strike price + Expected basis + Premium Paid Put Options give Floor Price with opportunities for higher prices. FP = Strike price + Expected basis – Premium Paid