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The Basics Of Using Put Options

I ve had many inquiries over the past few months about hedging feeder cattle using options. Last winter, I wrote an article on using futures markets to hedge feeder cattle, but many producers are hesitant to take an outright futures position given the potential for margin calls.

Many producers experience extremely tight cash flow during different periods of the year. There is also a tendency for a hedging position to turn into a speculative position once emotions start to take over. A futures option gives the producer limited risk exposure as the only amount of cash at risk is the initial cost of the option.

Options are often compared to fire insurance on a house. Buyers hope they never have to use it but it is there just in case. Options are similar because most options expire worthless, but are very useful during extreme price moves due to an adverse market event.

Put options can be used to set a price floor for feeder cattle production. A put option gives the buyer of the option the right to sell a futures contract at a specific price, which is commonly called the strike price.

Here s an example of how the process works:

In May, a cow-calf producer wants to set a price floor for feeder cattle that will be sold in October. The producer wants protection if the price declines; however, if the price increases, the producer wants to be able to take advantage of the higher price.

The October feeder cattle futures are trading at $138. A put option with a $134 strike price is trading for $2. (The cost of the option is often referred to as the option premium) The producer decides to buy this put option with the $134 strike price and sets the following expected floor price.

The price floor equals the strike price minus the premium, minus the basis. In this example, the floor price would be $134 minus $2 minus $10 equals $122. The basis is the difference between the cash price at the local auction market and the futures market. It is important that producers are familiar with local basis levels so they know what basis to use when calculating a floor price.

SCENARIO #1

In October, the futures price has fallen to $110. The producer sells the cattle at the local auction market for $100 because the basis has stayed at $10. Calculating the overall price received for the cattle would also include the gain in value of the put option.

In this example, the strike price was $134 and the current futures price was $110 which is a $24 gain. We also have to deduct the cost of the option which was $2. The net price is $100, which the producer received at the auction market, plus the gain on the option which is $24 minus the $2 premium which equals $122. The actual price received is exactly equal to the expected floor price because the basis stayed the same from April to October.

When the option is nearing expiry, the producer can exercise the option and take on a short futures position. In this example, the producer could be short at $134. The producer would then buy the futures position back at $110 and have a gain of $24. The producer can also sell the option back into the options market and an options trader will likely pay $23 or something close to $24, which is what the option is actually worth. The option trader has to endure some risk so he will bid just below the actual value of the option. In the real world, it may not balance out but it will be very close to the expected floor price.

SCENARIO #2

In October, the futures price is $154. The producer sells the feeder cattle at the local auction market for $144 as the basis remains at $10. In this example, there is no gain on the option because the futures price of $154 is higher than the strike price of $134. However, we have to subtract the premium of $2 which results in a net price of $142. In this example, the option expires worthless, similar to most fire insurance policies on houses.

A COUPLE OF POINTS

It is important to note that if the producer changes their market view in July, the rancher can always sell back the option into the options market. The option will have some time value, which is the value of the probability that the option will take on some intrinsic value at expiry. Intrinsic value for put options is when the strike price is higher than the futures price. If the producer decided to sell the option in July, the value might be $0.50 which is better than letting the option expire worthless. You also have to remember that the market can drop suddenly and then there would be no protection.

There are websites, books, and pamphlets that can help explain put options. This is a very simple explanation but it provides producers with an opportunity to learn the basics.

GeraldKlassenanalyzescattleandhogmarkets inWinnipegandalsomaintainsaninterestin thefamilyfeedlotinSouthernAlberta.For commentsorspeakingengagements,hecan bereachedat [email protected] or2042878268

About the author

Columnist

Jerry Klassen

Jerry Klassen is manager of the Canadian office for Swiss-based grain trader GAP SA Grains and Products Ltd. and also president and founder of Resilient Capital, a specialist in commodity futures trading and commodity market analysis. He can be reached at (204) 504-8339 or visit his website at www.resilcapital.com.

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