Options on Futures Separate market Option on the futures contract Can be bought or sold Behave like price insurance

– Is different from the new insurance products

Options on Futures

Two types of optionsFour possible positions – Put

» Buyer

» Seller

– Call» Buyer

» Seller

Put option The Buyer pays the premium and has the

right, but not the obligation to sell a futures contract at the strike price.

The Seller receives the premium and is obligated to buy a futures contract at the strike price.

Call option The Buyer pays a premium and has the

right, but not the obligation to buy a futures contract at the strike price.

The Seller receives the premium but is obligated to sell a futures contract at the strike price.

Options as price insurance

Person wanting protection pays a premium If damage occurs the buyer is reimbursed

for damages Seller keeps the premium but must pay for

damages

Options

May or may not have value at end– The right to sell at $2.20 has no value if the

market is above $2.20 Can be offset, exercised, or left to expire Calls and puts are not opposite positions of

the same market. They are different markets.

Strike price

Level of price insurance Set by the exchange (CME, CBOT) A range of strike prices available for

each contract

Premium Is traded in the option market

– Buyers and sellers establish the premium through open out cry in the trading pit.

Different premium– For puts and calls – For each contract month– For each strike price

In-the-money

If expired today it has value Put: futures price below strike price Call: futures price above strike price

At-the-money

If expired today it would breakeven Strike price nearest the futures price

Out-of-the-money

If expired today it does not have value Put: futures price above strike price Call: futures price below strike price

Option buyer alternatives

Let option expire– Typically when it has no value

Exercise right– Take position in futures market– Buy or sell at strike price

Re-sell option rights to another

Buyer decision depends upon

Remaining value and costs of alternative Time mis-match

– Most options contracts expire 2-3 weeks prior to futures expiration

– Cash settlement expire with futures– Improve basis predictability

Option seller

Obligated to honor option contract Can buy back option to offset position

– Now out of market

Put option example

A farmer has corn to sell after harvest.1) In May, buy a $2.80 Dec Corn Put

Expected basis = -$0.25Premium = $0.15Commission = $0.01

Expected minimum price (EMP) =SP + Basis - Prem - Comm = $2.39

Notice that you subtract the premium because it works against you and you are trying to reduce cost.

Put option example Lower

2) At harvest futures prices lower.

Futures = $2.50

Cash market = $2.25

Option value = $2.80-2.50 = $0.30

Net price = Cash + Return - Cost= $2.25 + 0.30 - 0.15 - 0.01 = $2.39

Put option example Higher

3) At harvest futures prices higher.

Futures = $3.15

Cash market = $2.90

Option value = $0

Net price = Cash + Return - Cost

= $2.90 + 0 - 0.15 - 0.01 = $2.74

Call option example

A feedlot wants to buy corn to feed after harvest.1) In May, buy a $3.00 Dec Corn Call

Expected basis = -$0.25Premium = $0.20Commission = $0.01

Expected maximum price (EMP) =SP + Basis + Prem + Comm = $2.96

Notice that you add the premium because it works against you and you are trying to reduce cost.

Call option example Lower

2) At harvest futures prices lower.

Futures = $2.50

Cash market = $2.25

Option value = $0

Net price = Cash - Return + Cost

= $2.25 - 0 + 0.20 + 0.01 = $2.46

Call option example Higher

3) At harvest futures prices higher.

Futures = $3.15

Cash market = $2.90

Option value = $3.15-3.00 = $0.15

Net price = Cash - Return + Cost

= $2.90 - 0.15 + 0.20 + 0.01 = $2.96

Net Price with Options

Buy Put– Minimum price– Cash price - premium - comm

Buy Call– Maximum price– Cash price + premium + comm

Livestock Risk Protection (LRP)

Coverage for hogs, fed cattle and feeder cattle

70% to 95% guarantees available, based on CME futures prices.

Coverage is available for up to 26 weeks out for hogs and 52 for cattle.

Livestock Risk Protection

Guarantees available are posted at: www.rma.usda.gov/tools/

Posted after the CME closes each day until 9:00 am central time the next working day.

Assures that guarantees reflect the most recent market movements.

Size of CoverageFutures and options have fixed

contract sizes– Hogs: 400 cwt. or about 150 head– Fed cattle: 400 cwt. or about 32 head– Feeder cattle: 500 cwt., 60-100 head

LRP can be purchased for any number of head or weight

Some Risks Remain LRP, LGM do not insure against

production risks Futures prices and cash index prices

may differ from local cash prices (basis risk)

Selling weights and dates may differ from the guarantees

Expiration Date of Coverage

LRP ending date is fixed. Price may change after date of sale.

Hedge or options can be lifted at any time before the contract expires.

Who can benefit from LGM/LRP? Producers who depend on the daily cash

market or a formula related to it. Producers with low cash reserves. Smaller producers who do not have the

volume to use futures contracts or put options.

Producers who prefer insurance to the futures market. No margin account.

LRP Analyzer Covers swine, fed cattle, feeders Compares net revenue distribution

– No risk protection

– LRP

– Hedge

– Put options

Case Example Small cow herd producer will have

62 head of 650 pound steer calves to sell in 4 months.

What price will LRP lock in? How much will it cost? How does LRP compare to futures?

Projected Net Revenue per Head

($50)

$0

$50

$100

$150

$200

$250

$89.00 $94.00 $99.00 $104.00 $109.00 $114.00 $119.00 $124.00Cash Selling Price, $/cwt.

$/head

LRP highest level

PUT Options

Hedge

No Risk Protection

Projected Net Revenue per Head

($50)

$0

$50

$100

$150

$200

$250

$89.00 $94.00 $99.00 $104.00 $109.00 $114.00 $119.00 $124.00Cash Selling Price, $/cwt.

$/head

LRP highest level

PUT Options

Hedge

No Risk Protection

Livestock Gross Margin

Cattle– Calves– Yearlings

Hogs– Farrow to finish– Finishing feeder pig– Finishing SEW pig

Livestock Gross Margin

Insures a “margin” between revenue and cost of major inputs

Hogs

Value of hog – corn and SBM costs

Cattle

Value of cattle – feeder cattle and corn

Protects against decreases in cattle/hog prices increases in input costs

LGM Hogs Farrow to Finish option Gross margin per hogt =

– 2.5*0.74*LeanHog Pricet

– - 13.22 bu. * Corn Pricet-3– - (188.52 lb./2000 lb.) * SoyMeal Pricet-3

Finish Only option Gross margin per hogt =

– 2.5*0.74*Lean Hog Pricet

– - 10.19 bu. * Corn Pricet-2– - (147.31 lb./2000 lb.) * SoyMeal Pricet-2

LGM-Cattle

Uses futures markets to lock in the average expected gross margin for fed cattle to be sold in each of the next ten months

Protects against decreases in live cattle prices increases in feeder cattle prices and increases in feed costs

LGM-Cattle

Yearling GM = 12.5 x Basis adjusted LC futures

- 7.5 x Basis adjusted FC futures

- 57.5 x Basis adjusted Corn futures

Calf  GM = 11.5 x Basis adjusted LC futures

- 5.5 x Basis adjusted FC futures

- 55.5 x Basis adjusted Corn futures

Learn More About Risk Tools

Livestock Revenue Protection Livestock Gross Margin http://www.rma.usda.gov/livestock/

– Factsheets– Premium calculator

Livestock Futures and Options Historic basis patterns www.extension.iastate.edu/agdm

– Decision file B1-50