Hedging with Wheat Options Minneapolis Grain Exchange 1
TYPES OF OPTIONS Put Option: the right to SELL a futures contract at a fixed price before an expiration date Call Option: the right to BUY a futures contract at a fixed price before an expiration date 2
STRIKE PRICE AND PREMIUM Strike (Exercise) Price: The fixed price at which the option holder has the right to buy (call option) or sell (put option) a futures contract. In MGE wheat, strike prices are listed every $0. 10 per Bu. $3.70 $3.80 $3.90 $4.00 Premium: The cost of an option. quoted in cents per Bu varies from minute-to-minute as the underlying futures price changes 3
PUT PREMIUM Example: Buy a $4.00 PUT when futures are at $ $4.00 Increases in value as market falls Decreases in value to zero as market rises Futures Strike Price Example Premium (at expiration) $4.40 $0.00 $4.20 $0.00 $4.00 $4.00 Put $0.00 $3.80 $0.20 $3.60 $0.40 No value When you have The right to sell Lower than futures. Right to sell futures above the current price value here. 4
CALL PREMIUM Example: Buy a $4.00 CALL when futures are at $ $4.00 Increases in value as market rises Decreases in value to zero as market falls Futures Strike Price Example Premium (at expiration) $4.40 $0.40 $4.20 $0.20 $4.00 $4.00 Call $0.00 $3.80 $0.20 $3.60 $0.40 Right to buyer Lower than futures Has value Right to buy higher Than futures has no Value at expiration. 5
PUT OPTION PREMIUM Option Premium is composed of two parts: Intrinsic Value Time Value If futures = $4.00 and Put Strike Prices = $3.80 $4.00 $4.20 Intrinsic Value = Minimum value $0.00 $0.00 $0.20 Time Value = Volatility of futures Time to expiration Interest rates $0.10 $0.20 $0.15 Total Premium = $0.10 $0.20 $0.35 6
CALL OPTION PREMIUM Option Premium is composed of two parts: Intrinsic Value Time Value If futures = $4.00 and Call Strike Prices = $3.80 $4.00 $4.20 Intrinsic Value = Minimum value $0.20 $0.00 $0.00 Time Value = Volatility of futures Time to expiration Interest rates $0.15 $0.20 $0.10 Total Premium = $0.35 $0.20 $0.10 7
OPTIONS RELATIONSHIP TO FUTURES Futures price = $4.00 Puts Calls In-the-money $4.20 $3.80 At-the-money $4.20 $3.80 Out-of-the-money $4.20 $3.80 Strike prices with intrinsic value are in-the-money 8
PUT OPTION-- BUYERS AND SELLERS Put Option Buyer: Pays premium Has right to exercise into a short futures position Pays no margin Put Option Seller: Collects premium Has obligation to accept a long futures position if assigned Insures put buyer by margining 9
CALL OPTION-- BUYERS AND SELLERS Call Option Buyer: Pays premium Has right to exercise into a long futures position Pays no margin Call Option Seller: Collects premium Has obligation to accept a short futures position if assigned Insures call buyer by margining 10
PREMIUM EXAMPLE SEP Futures = $ 4.00 A. Premium quote ($/bu.) $4.00 put option = $0.20/bu. B. Total premium $0.20 x 5,000 = $1,000 / contract C. Option offset Put Option If value at expiration: Sell back or Take short futures No value let expire Call Option If value at expiration: Sell back or Take long futures position No value let expire 11
CALCULATING A FLOOR PRICE Buy a(n) SEP HRS Wheat $ 4.00 Put Strike Price = $ 4.00 - Premium = - 0.20 " Basis = 0.00 (best to use local basis estimate) Estimated Floor Price = $ 3.80 Estimated Floor Price: Minimum selling price as market price declines, put option gains value. Unlimited Upside Potential: If market prices increase, net selling price = higher cash price minus premium paid Pay Premium: premium paid in full up front -- no margin obligations
CURRENT EXAMPLE - BUYING PUTS A. Date April 15 Market Close MGE SEP HRS Futures = $ 4.00 MGE SEP $ 4.20 put = $ 0.35 per Bu MGE SEP $ 4.00 put = $ 0.20 per Bu MGE SEP $ 3.80 put = $ 0.10 per Bu B. Pricing Opportunities $ 4.00 " $ 0.00 = $ 4.00 futures basis Strike Price - Premium " Basis = Minimum Price $4.20 - $0.35 " $0.00 = $3.85 $4.00 - $0.20 " $0.00 = $3.80 $3.80 - $0.10 " $0.00 = $3.70 C. Offset $4.00 put end of August sell back Futures Actual Cash Option Gain Net Sell Price (Loss) $5.00 $5.00 + $0.00 0.20 = $4.80 $4.00 $4.00 + $0.00 0.20 = $3.80 $3.00 $3.00 + $1.00 0.20 = $3.80 Value at Expiration premium paid 13
RISK PROFILE FUTURES VS. CASH MARKET SALE VS. PUT OPTION 14
SELL WHEAT- BUY A CALL Sell wheat for $ 3.00 /bushel at harvest Buy a(n) MGE HRS MAR CaII Cash Price = $ 3.00 - Premium = $ 0.20 Estimated Selling Price = $ 2.80 Estimated Selling Price: Minimum selling price as market price increases, call option gains value. Unlimited Downside Potential: If market prices decreases, net purchase price = cash price minus premium paid Pay Premium: premium paid in full up front -- no margin obligations 15
A. Date August 15 Market Close Cash Sale Price = $ 3.00 per bushel CURRENT EXAMPLE - BUYING CALLS MGE MAR $ 3.20 call = $ 0.10 per Bu MGE MAR $ 3.00 call = $ 0.20 per Bu MGE MAR $ 2.80 call = $ 0.35 per Bu B. Pricing Opportunities $ 4.00 " $ 0.00 = $ 4.00 futures basis Cash Price - Premium " Basis = Minimum Price $3.00 - $0.10 " $0.00 = $2.90 $3.00 - $0.20 " $0.00 = $2.80 $3.00 - $0.35 " $0.00 = $2.65 C. Offset End of February $3.20 call Futures Cash Price Option Gain Net Sell Price (Loss) $4.00 $3.00 + $0.80 0.10 = $3.70 $3.00 $3.00 + $0.00 0.10 = $2.90 $2.00 $3.00 + $0.00 0.10 = $2.90 Received Value at premium In Aug Expiration paid
RISK PROFILE FUTURES VS. CASH MARKET SALE VS. CALL OPTION 17