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Marketing Biofuels Powerpoint 2 - of Agricultural Economics

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




                    Ethanol
For more information
about reading charts, see
CMS Disk 2, Unit 6 on
Technical 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 right, but not
  the 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 option is the right to buy the
  underlying futures contract at a
  predetermined price prior to expiration.

• A put 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 price or the
  exercise price.

• The premium 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
 strikes 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
• Premiums 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-money: An option is said to be in-the-
  money if it is profitable to exercise.

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

• At-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 Value
                                  Value of $3.60 Dec07 Corn Put Premium
                                          Depending on Volatility
                     $0.45
                     $0.40
                     $0.35
Put Premium ($/bu)




                     $0.30
                     $0.25
                     $0.20
                     $0.15
                     $0.10
                     $0.05
                     $0.00
                             16    18   20   22   24   26      28     30     32   34   36   38   40
                                                            Volatility (%)
   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 Remorse: Option hedgers
  can take advantage of favorable price
  movements.

• Posting 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?

           November futures:      $5.75
           Put option @ $5.75: 25 cents
           Put option @ $5.50: 15 cents


   Which strike do you select?
                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
Minimum Price = Strike Price
                - Premium
                - Expected Basis
                - Hedging Costs (Interest/Brokerage Fee)


  Min. Price = $3.80 - $0.35 - $0.20- $0.02 = 3.23
      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
         Example--Put, Prices Fall
Net Price =        $3.00 (Futures Price)
                                              Cash Price
                   - 0.20 (Basis)
                    -0.35 (premium)
 The Minimum        -0.02
     Price!
                   +0.80 (Options Gain:$3.80-3.00 )
                   $3.23 Net Price per bushel
    Net Price =
       Futures Price +(-) Basis - Premium - Hedging Costs
               + Options Gain (Strike-Futures)
 Example--Put ,Prices Increase Slightly
Net Price =        $4.00 (Futures Price)
                   -0.20 (Basis)
                   -0.35 (premium)
                   -0.02 (hedging) costs
                   +0 (Options Gain:$3.80-4.00=0 )
                   $3.43 Net Price per cwt

    Net Price =
       Futures Price +(-) Basis - Premium - Hedging Costs
               + Options Gain
   Example--Put, Price Increase! Yahoo!
 Net Price =      $4.40    (Futures Price)
                  -0.20    (Basis)
                  -0.35    (premium)
Above the Minimum -0.02    (hedging costs)
      Price!
                  +0.00    (Options Gain)
                  $3.83    Net Price per cwt
     Net Price =
        Futures Price +(-) Basis - Premium - Hedging Costs
                + Options Gain
    Buy a Put Example Summary
 Buying a put establishes a minimum price
 Strike: $3.80
 Premium: $0.35             Basis: -$0.20
Futures   Cash    Buy $3.80 Put
3.40       3.20        3.23             Price
3.60       3.40        3.23             Floor
3.80       3.60        3.23
4.00       3.80        3.43
                                        Upside
4.20       4.00        3.63             Potential
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
$3.90 Dec07 corn put costs $0.38
$4.40 Dec07 corn put costs $0.71
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
Minimum Price = Cash Price
                - Premium
                - Hedging Costs (Interest/Brokerage Fee)



  Min. Price = $4.00 - $0.28- $0.02 = $3.70/bushel
  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
  Example—Cash & Call, Prices Fall

Net Price =         $4.00 (Cash Price)
                    -0.28 (premium)
 The Minimum         -0.02
     Price!         +0 (no gain on options)
                    $3.70 Net Price per bu


    Net Price =
        Cash Price - Premium - Hedging Costs + Options Gain
 Example—Cash & Call , Futures Price
Increases Slightly (from $4.25 to $4.50)
Net Price = $4.00 (Cash Price)
                  -0.28 (premium)
                  -0.02 (hedging) costs
 The Minimum
     Price!       +0 (Options Gain)
                  $3.70 Net Price per cwt


  Net Price =
     Cash Price - Premium - Hedging Costs + Options Gain
   Example—Cash & Call, Futures Price
     Increases (from to $5.00) Yahoo!
 Net Price =      $4.00      (Cash Price)
                  -0.28      (premium)
Above the Minimum -0.02      (hedging costs)
      Price!      +0.50      (Options Gain: $5.00-$4.50)
                  $4.20      Net Price per bu


    Net Price =
        Cash Price - Premium - Hedging Costs + Options Gain
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: $4.50
Premium: $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                 Price
                                              Floor
4.20      4.20           3.70
4.40      4.40           3.70
4.60      4.60           3.80
                                              Upside
4.80      4.80           4.00
                                              Potential
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
Maximum Price = Strike Price
               + Premium
               - Expected Basis
               - Hedging Costs (Interest/Brokerage Fee)


  Max. Price = $4.00 + $0.36 - $0.20- $0.02 = 4.14
 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
    Example—Sell Call, Prices Fall
Net Price =        $3.00 (Futures Price)
                                              Cash Price
                   - 0.20 (Basis)
                    +0.36 (premium)
                    -0.02
                   +0 (Options Loss:$3.00-4.00 )
                   $3.14 Net Price per bushel
    Net Price =
       Futures Price +(-) Basis + Premium - Hedging Costs
               - Options Loss (Futures-Strike)
  Example—Sell Call ,Prices Increase
            Slightly
Net Price =        $4.20 (Futures Price)
                   -0.20 (Basis)
                   +0.36 (premium)
The Maximum        -0.02 (hedging) costs
    Price          -.20 (Options Loss:$4.00-4.20=-.20 )
                   $4.14 Net Price per cwt

    Net Price =
       Futures Price +(-) Basis + Premium - Hedging Costs
               - Options Loss
  Example—Sell Call, Price Increase
Net Price =        $4.60 (Futures Price)
                    -0.20 (Basis)
                    +0.36 (premium)
 Still Maximum      -0.02 (hedging costs)
       Price
                   -0.60 (Options Loss)
                   $4.14 Net Price per cwt
    Net Price =
       Futures Price +(-) Basis + Premium - Hedging Costs
               - Options Loss
    Sell a Call Example Summary
 Selling a call establishes a maximum price
 Strike: $4.00
 Premium: $0.36               Basis: -$0.20
Futures   Cash    Sell $4 Call
3.40       3.20         3.54             Limited
3.60       3.40         3.74             downside
                                         protection
3.80       3.60         3.94
4.00       3.80         4.14
                                         Price
4.20       4.00         4.14             Ceiling
4.40       4.20         4.14
4.60       4.40         4.14
 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
 Buy $3.60 Put for $0.26 per bushel
 Sell $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               Price
3.60        3.40           3.40               Floor
3.80        3.60           3.60               Open
4.00        3.80           3.80               window
4.20        4.00           4.00
4.40        4.20           4.00                Price
                                               Ceiling
4.60        4.40           4.00
 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 Summary
1. 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                 5 th:   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:
• cealexan@purdue.edu

				
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