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USES OF OPTIONS: HEDGING Spot price risks: 1.Risk of spot price FALL –Person/firm committed to sell good (output) in the future 2.Risk of spot price RISE.

Published bySara Woods Modified over 8 years ago

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Presentation on theme: "USES OF OPTIONS: HEDGING Spot price risks: 1.Risk of spot price FALL –Person/firm committed to sell good (output) in the future 2.Risk of spot price RISE."— Presentation transcript:

1 USES OF OPTIONS: HEDGING Spot price risks: 1.Risk of spot price FALL –Person/firm committed to sell good (output) in the future 2.Risk of spot price RISE –Person/firm committed to buy good (input) in the future

2 USES OF OPTIONS: HEDGING “Equal and opposite position” Short (or Selling) Hedge: – Protects from FALL in spot price –Benefit in futures from a price fall to offset the loss in the cash market

3 USES OF OPTIONS: SHORT HEDGE

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7 USES OF OPTIONS: HEDGING Short (or Selling) Hedge: –Buy a put option –Protects from FALL in spot price –“Locks in” a SELLING FLOOR price

8 USES OF OPTIONS: SHORT HEDGE

9 USES OF OPTIONS: HEDGING Short (or Selling) Hedge: – Protects from FALL in spot price –“Locks in” a SELLING FLOOR price Long (or Buying) Hedge: – Protects from RISE in spot price

10 USES OF OPTIONS: LONG HEDGE

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14 USES OF OPTIONS: HEDGING Short (or Selling) Hedge: – Protects from FALL in spot price –“Locks in” a SELLING FLOOR price Long (or Buying) Hedge: –Buy a call –Protects from RISE in spot price –“Locks in” a BUYING CEILING price

15 USES OF OPTIONS: LONG HEDGE

16 SHORT-HEDGING WITH OPTIONS Protection from FALL in spot price “Lock in” selling FLOOR price

17 OPTIONS: SHORT HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to sell Buy PUTs (Long in spot)(Right to be short in futures)

18 OPTIONS: SHORT HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to sell Buy PUTs (Long in spot)(Right to be short in futures) LATER:Sell commoditySell back PUTs, or let (Spot positionPUTs expire cleared) (PUT position cleared)

19 USES OF OPTIONS: SHORT HEDGE

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21 PUT Strike - PUT Premium + Expected Basis Expected Selling FLOOR Price OPTIONS: SHORT HEDGE

22 EXAMPLE of Short Hedge with Options: CORN PRODUCER It is April 2005. You are about to plant corn. Current December futures price is $2.35/bu. Basis in mid-November has been: $0.25/bu (in ’04), $0.28/bu (in ’03), $0.30/bu (in ’02), $0.32/bu (in ’01), $0.30/bu (in ’00), $0.33/bu (in ’99), $0.36/bu (in ’98) under December, so your predicted basis is $0.32/bu under December. Expected spot price for mid-November 2005 = $2.03/bu (= 2.35 – 0.32)

23 EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price 2.20 - 0.11 + (-0.32) = 1.77

24 SHORT-HEDGING WITH OPTIONS

25 EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price 2.20 - 0.11 + (-0.32) = 1.77 2.30 - 0.16 + (-0.32) = 1.82

26 SHORT-HEDGING WITH OPTIONS

27 EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price 2.20 - 0.11 + (-0.32) = 1.77 2.30 - 0.16 + (-0.32) = 1.82 2.40 - 0.22 + (-0.32) = 1.86 2.50 - 0.28 + (-0.32) = 1.90 2.60 - 0.35 + (-0.32) = 1.93

28 SHORT-HEDGING WITH OPTIONS

29 EXAMPLE of Short Hedge with Options: CORN PRODUCER December Current ExpectedExpected PUT - December + November = Selling Strike PUT Basis FLOOR Premium Price 2.20 - 0.11 + (-0.32) = 1.77 2.30 - 0.16 + (-0.32) = 1.82 2.40 - 0.22 + (-0.32) = 1.86 2.50 - 0.28 + (-0.32) = 1.90 2.60 - 0.35 + (-0.32) = 1.93

30 EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 1: Futures FALL from 2.35 to 1.85 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec. 2.50 strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu

31 EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 1: Futures FALL from 2.35 to 1.85 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec. 2.50 strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $1.53/buSell back for $0.65/buActual -$0.32

32 EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 1: Futures FALL from 2.35 to 1.85 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec. 2.50 strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $1.53/buSell back for $0.65/buActual -$0.32 Spot Price+PUT Gain (Loss)= Net Selling Price $1.53/bu+$0.37 = $1.90 (as expected)

33 EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 2: Futures RISE from 2.35 to 2.70 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec. 2.50 strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu

34 EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 2: Futures RISE from 2.35 to 2.70 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec. 2.50 strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $2.38/buSell back for $0/buActual -$0.32

35 EXAMPLE of Short Hedge with Options: CORN PRODUCER Scenario 2: Futures RISE from 2.35 to 2.70 SPOTPUTBASISACTIVITY APR. ExpectedBuy Dec. 2.50 strikeExpected -$0.32 Floor $1.90/bufor $0.28/bu NOV. Sell $2.38/buSell back for $0/buActual -$0.32 Spot Price+PUT Gain/Loss= Net Selling Price $2.38/bu+($-0.28) = $2.10 (as expected)

36 EXAMPLE of Short Hedge with Options: CORN PRODUCER December Expected Net Selling Price PUT Selling (November spot = $1.53/bu) Strike FLOOR (Futures = $1.85/bu) (Premium) Price 2.20 (0.11) 1.77 1.77 2.30 (0.16) 1.82 1.82 2.40 (0.22) 1.86 1.86 2.50 (0.28) 1.90 1.90 2.60 (0.35) 1.93 1.93

37 SHORT-HEDGING WITH OPTIONS

38 EXAMPLE of Short Hedge with Options: CORN PRODUCER December Expected Net Selling Price PUT Selling (November spot = $2.38/bu) Strike FLOOR (Futures = $2.70/bu) (Premium) Price 2.20 (0.11) 1.77 2.27 2.30 (0.16) 1.82 2.22 2.40 (0.22) 1.86 2.16 2.50 (0.28) 1.90 2.10 2.60 (0.35) 1.93 2.03

39 SHORT-HEDGING WITH OPTIONS

40 EXAMPLE of Short Hedge with Options: CORN PRODUCER December Expected Net Selling Price PUT Selling (Nov. spot (Nov. spot Strike FLOOR = $1.53/bu) = $2.38/bu) (Premium) Price (Fut. = $1.85/bu) (Fut. = $2.70/bu) 2.20 (0.11) 1.77 1.77 2.27 2.30 (0.16) 1.82 1.82 2.22 2.40 (0.22) 1.86 1.86 2.16 2.50 (0.28) 1.90 1.90 2.10 2.60 (0.35) 1.93 1.93 2.03

41 SHORT-HEDGING WITH OPTIONS

42 OPTIONS: SHORT HEDGING Many possible FLOOR prices –Must pick “right” one for your situation Note: Actual FLOOR  expected FLOOR only if Actual Basis  expected Basis

43 LONG-HEDGING WITH OPTIONS Protection from RISE in spot price “Lock in” buying CEILING price

44 OPTIONS: LONG HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to buy Buy CALLs (Short in spot)(Right to be long in futures)

45 OPTIONS: LONG HEDGE SPOT MARKETOPTIONS MARKETACTIVITY NOW:Committed to buy Buy CALLs (Short in spot)(Right to be long in futures) LATER:Buy commoditySell back CALLs, or (Spot positionlet CALLs expire cleared) (CALL position cleared)

46 USES OF OPTIONS: LONG HEDGE

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48 CALL Strike + CALL Premium + Expected Basis Expected Buying CEILING Price OPTIONS: LONG HEDGE

49 EXAMPLE of Long Hedge with Options: SOY PROCESSOR It is April 2005. You will buy soybeans in late October. Current November futures price is $6.15/bu. Basis in late October has been $0.32/bu under November. Expected spot price for late October 2005 = $5.83/bu (= 6.15 – 0.32)

50 EXAMPLE of Long Hedge with Options: SOY PROCESSOR November Current ExpectedExpected CALL + November - October = Buying Strike CALL Basis CEILING Premium Price 6.00 + 0.54 - (-0.32) = 1.77

51 SHORT-HEDGING WITH OPTIONS

52 EXAMPLE of Long Hedge with Options: SOY PROCESSOR November Current ExpectedExpected CALL + November - October = Buying Strike CALL Basis CEILING Premium Price 6.00 + 0.54 - (-0.32) = 1.77 6.20 + 0.46 - (-0.32) = 1.82 6.40 + 0.39 - (-0.32) = 1.86 6.60 + 0.33 - (-0.32) = 1.90 6.80 + 0.28 - (-0.32) = 1.93

53 SHORT-HEDGING WITH OPTIONS

54 EXAMPLE of Long Hedge with Options: SOY PROCESSOR November Current ExpectedExpected CALL + November - October = Buying Strike CALL Basis CEILING Premium Price 6.00 + 0.54 - (-0.32) = 1.77 6.20 + 0.46 - (-0.32) = 1.82 6.40 + 0.39 - (-0.32) = 1.86 6.60 + 0.33 - (-0.32) = 1.90 6.80 + 0.28 - (-0.32) = 1.93

55 EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 1: Futures FALL from 6.15 to 5.60 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov. 6.40 strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu

56 EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 1: Futures FALL from 6.15 to 5.60 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov. 6.40 strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $5.28/buSell back for $0/buActual -$0.32

57 EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 1: Futures FALL from 6.15 to 5.60 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov. 6.40 strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $5.28/buSell back for $0/buActual -$0.32 Spot Price -CALL Gain/Loss= Net Buying Price $5.28/bu -($-0.39/bu)= $5.67 (as expected)

58 EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 2: Futures RISE from 6.15 to 7.10 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov. 6.40 strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu

59 EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 2: Futures RISE from 6.15 to 7.10 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov. 6.40 strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $6.78/buSell back for $0.70/buActual -$0.32

60 EXAMPLE of Long Hedge with Options: SOY PROCESSOR Scenario 2: Futures RISE from 6.15 to 7.10 SPOTCALLBASISACTIVITY APR. ExpectedBuy Nov. 6.40 strikeExpected -$0.32 Ceiling $6.47/bufor $0.39/bu OCT. Buy $6.78/buSell back for $0.70/buActual -$0.32 Spot Price -CALL Gain/Loss= Net Buying Price $6.78/bu -$0.31/bu= $6.47 (as expected)

61 EXAMPLE of Long Hedge with Options: SOY PROCESSOR December Expected Net Buying Price CALL Selling (October spot = $5.28/bu) Strike CEILING (Futures = $5.60/bu) (Premium) Price 6.00 (0.54) 6.22 5.82 6.20 (0.46) 6.34 5.74 6.40 (0.39) 6.47 5.67 6.60 (0.33) 6.61 5.61 6.80 (0.28) 6.76 5.56

62 SHORT-HEDGING WITH OPTIONS

63 EXAMPLE of Long Hedge with Options: SOY PROCESSOR December Expected Net Buying Price CALL Selling (October spot = $6.78/bu) Strike CEILING (Futures = $7.10/bu) (Premium) Price 6.00 (0.54) 6.22 6.22 6.20 (0.46) 6.34 6.34 6.40 (0.39) 6.47 6.47 6.60 (0.33) 6.61 6.61 6.80 (0.28) 6.76 6.76

64 SHORT-HEDGING WITH OPTIONS

65 EXAMPLE of Long Hedge with Options: SOY PROCESSOR December Expected Net Buying Price CALL Selling (Oct. spot (Oct. spot Strike CEILING = $5.28/bu) = $6.78/bu) (Premium) Price (Fut. = $5.60/bu) (Fut. = $7.10/bu) 6.00 (0.54) 6.22 5.82 6.22 6.20 (0.46) 6.34 5.74 6.34 6.40 (0.39) 6.47 5.67 6.47 6.60 (0.33) 6.61 5.61 6.61 6.80 (0.28) 6.76 5.56 6.76

66 SHORT-HEDGING WITH OPTIONS

67 OPTIONS: LONG HEDGING Many possible CEILING prices –Must pick “right” one for your situation Note: Actual CEILING  expected CEILING only if Actual Basis  expected Basis

68 Futures Net Price Strike Price Long Cash Adjust for basis Hedge Adjust for basis Buy Put Hedger Position

69 Futures Net Price Strike Price Long Cash Adjust for basis Hedge Adjust for basis Buy Call Hedger Position

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