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7/24/2019 Aplications Using Options
1/50
gricultural
conomics Rpt No.
200
Commercial
nd
Producer
Applications
Using
Options
on
rain
Futures
by
John
P Satrom
Alfred K
Chan
William
W Wilson
Department
of
gricultural
Economics
gricultural
Experiment
Station
North Dakota
State
University
Fargo
North Dakota
581 5
May
198
7/24/2019 Aplications Using Options
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i hli hts
Trading
of
options on agricultural
commodity futures began
on
an
experimental basis in
ctober 1984. This report
provides
a
brief
descrip-
tion on use of
options by
merchants
and
producers. The
advantage
of using
options is
their ability to
lock
in a
floor or ceiling
price for the
underlying
future allowing the
merchant
or
producer to
take
advantage
of
favorable
price
movements.
To do so the he ger
pays premium.
n
this
sense
options
are analogous
to price insurance whereby
a
premium is
paid
to
protect against an
adverse
movement in
prices.
Options can be viewed
as
an innovation
or new
technology in he
marketing system.
They
can
be
used for a
multitude
of purposes including
hedging
long and short cash positions forward contracting s well as
speculating.
n
many cases options are
more appropriate
hedging vehicles
when
quantity
or yield
risk
is present.
Mechanics and examples of each
of
these applications
are
presented in this
publication.
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TABLE
OF
CONTENTS
Page
List
of
Tables
.
.
.
ii
List of
Examples
.
. .
ii
List of
Figures
.
.
.
.
Commodity
Options:
Introduction
1
History
.
1
Definitions
.
2
Simple
Mechanics
of Option
Trading
.
3
Buying
Puts
.
4
Buying
Calls
.
4
Selling
Puts
.
.
5
Selling
Calls
.
5
Summary
on
Use of
Options
Versus
Futures
.
6
Application
of Options
by Merchants
8
Long
Cash
.
. .
.
8
Long
Cash/Long
Puts
.
9
Long
Cash/Short
Calls
.
. 10
Summary
of
Long
Cash Position
..
11
Short
Cash
.
11
Short
Cash/Long
Calls
.
13
Short
Cash/Short
Puts
.
14
Summary
of
Short
Cash
Position
.
15
Forward
Contracts
with Floor
and
Ceiling
Prices
.
17
Forward
Contracts
with
Floor
Prices
.
17
Forward
Contracts
with
Ceiling
Prices
.
19
Summary
of
Forward
Contracts
.
. 21
Quantity
Risk
. 22
Overnight Transactions
.
.
.
22
Summary
of
Quantity
Risk
.
. 25
Selected
Decisions
to
be
Made
in he
Use of
Options
.
26
Terminating
Option
Positions
.
. 26
In the Money
Vs.
Out of the Money
Options
.
27
Long
Cash/Long
Puts
.
...
...
.
27
Short
Cash/Long
Calls
.
.
30
Summary
of
Options
31
Pricing
of Commodity
Options
.
.
.
33
Concept
.
...........
Length
of Time
.
...........
33
Market Volatility
.
34
Interest
Rates
. 36
Relationships
Between
Market
and Strike
Price
.
.
36
Black Scholes
Pricing
Model
.
........
38
Delta
Factor
.
.. 41
Recent
Premiums
.
. . 41
Summary
.
.....
Selected Bibliography
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List
of
Tables
Table
No.
Pag
1
MERCHANT
CASH
POSITIONS
AND
USE OF
FUTURES
AND OPTIONS
7
2
OUT OME
OF
A
CH NGE
N
FUTURES
PRICES
O
LONG
ITM ND
OTM
POSITIONS
..
. .
.
............
.
....
.
3
3
OPTION
PREMIUMS
FOR
VARIABLE
MATURITIES
.
34
4
OPTION
PREMIUMS
FOR
DIFFERENT
LEVELS
OF
MARKET
VOLATILITY
.
36
5
OPTION
PREMIUMS
FOR
VARIABLE
INTEREST
RATE
37
6 OPTION
PREMIUMS
FOR
VARIABLE
STRIKE
PRICE
37
7
INTRINSIC
AND
EXTRINSIC
VALVE
FOR DIFFERENT
STRIKE
PRICES
OF
CALL
OPTIONS
38
8
OPTION
PREMIUMS
AND
DELTA
COMPUTED
FROM
BLACK/SCHOLES
MODEL
.
40
9
FUTURES
AND
OPTION
PRICES:
MINNEAPOLIS
WHEAT
AND
CHICAGO
SOYBEANS,
NOVEMBER
1984
TO FEBRUARY
1985
.
42
List
of
Examples
Example
No.
Page
1
LONG
CASH/LONG
PUTS
.....
.
.
10
2 LONG
CASH/SHORT
CALLS
12
3 SHORT
CASH/LONG
CALLS
14
4 SHORT
CASH/SHORT
PUTS
.
.
6
5 DERIVATION
OF
FORWARD
CONTRACTS I.E.,
PRODUCERS WITH
PRICE
FLOOR
.
. .
..
18
6
DERIVATION OF
FORWARD
CONTRACTS FOR SALE
E.G.,
TO IMPORTERS
WITH
PRICE CEILING
.
.
20
7
OVERNIGHT SALE
TRANSACTION
.
23
8 OVERNIGHT
PURCHASE
TRANSACTION
.
..
24
ii
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COMMERCIAL
ND
PRODUCER
APPLICATIONS
USING
OPTIONS
ON GRAIN
FUTURES
John
Satrom,
Alfred
Chan,
and William
Wilson
Commodity
Options:
Introduction
History
Commodity
options
have
had
a history
of adversity
and
diversity.
Grain
options
began
trading
on
the Chicago
Board
of Trade
as
early
as
the
Civil
War.
Shortly
after
their
introduction,
however,
the Board
of
Trade
tried
to cease
trading
because
of perceived
abuses.
The
state
of Illinois
banned
option
trading
both
on
and
off
exchanges,
but
trading
continued
despite
this
statutory
ban.
Further
restrictions
came
in
887
when
the
Board
of Trade
found
it
ecessary
to
restrict
option
trading
y its
members. Agricultural options
were then
alternately traded
and banned
between
1887
and
1936.
In 936,
Congress
banned
the trading
of
agricultural
options
completely
with
the
Commodity
Exchange
Act
of
1936.
number
of
factors
caused
the
1936
ban,
including
the following:
options
were
not
being
used
for
traditional
risk-shifting
purposes,
small
traders
lured
into
options
markets
to speculate
usually
lost money,
large
traders
could
use
options
to cause
artificial
price
movements,
terms
and
conditions
of
options
were
not
standardized,
and
congestion
near
the
close
of
the
market
could
occur
because
many
options
were
good
for
less
than
a
day
(Horner
and
Moriority
1983).
specific
case
occurred
in
he early
1930s when
options
were blamed
for
the excessive
price
movements
in
heat,
which
led
to
the collapse
of
the Chicago
Board
of
Trade's
wheat
market
in
1933.
Trouble
continued
to occur
in
he
late 1960s
and early
1970s
when
gold
options
were
being
sold
fraudulently.
The
problems
all
seemed
to stem
from
the
lack of
one
specific
governing
body.
After
the gold
incident,
the
Commodity
Futures
Trading
Commission
(CFTC)
was
given
full
control
of
all commodity
futures
and
options
trading.
The
commission
has worked
to
develop
regulations
for
exchange-traded
options,
and in
eptember
1981
the CFTC
approved
a
three-
year
pilot
program
including
options
trading
in
old,
treasury
bonds,
and
sugar.
Following
this,
the
Futures
Trading
Act
of
1982
lifted
the 1936
ban
on agricultural
options.
The result
was
development
of an experimental
three-year
program
of organized
trading
in selected
agricultural
options
which was introduced
in
October 1984.
Satrom
and
Chan
are
graduate
research
assistants
and
Wilson
is
associate
professor,
Department
of
Agricultural
Economics,
North
Dakota
State
University,
Fargo.
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3
Out-of-the-
Money
Intrinsic
Value
Time
or
Extrinsic
Value
Expiration
Date
Breakeven
Level
call
(put)
is
ut-of-the-money
if ts
strike
price
is
above
(below)
the
current
price
of
the
underlying
futures
contract.
The
option,
call
or
put,
has
no
intrinsic
value.
component
of the
option
premium
which
is easured
in
a
dollar
amount
if ny)
by
which
the
current
market
price
of the
underlying
futures
contract
is bove
the
strike
price for
the
call option
and below
the strike
price
for
the
put option.
Both
at-the-money
and
out-of-the-money
options
have
no
intrinsic
value.
Another
component
of
an
option
premium,
measured
by
the
amount
by
which
the
premium
exceeds
the
intrinsic
value
of the
option
Time
Value
=
Premium
Intrinsic Value
The date
that
is
he
last
day
that
a
holder of
a
put or
call
option
may
exercise
his
or her
right
to buy
or
sell
the underlying
futures
contract
at
the option
strike
price.
After
the
expiration
date,
the option
contract
becomes
null
and void.
The
expiration
dates
will
parallel
futures
contract
months.
For
example,
a
September
spring
wheat
option
on a September
spring
wheat
futures
contract
will
expire at
least
ten days
prior
to
the
first
notice day
of
the
September
futures
contract.
There is
a separate
breakeven
level
for both
call and
put options.
For
the
call
option,
the breakeven
level
equals
the strike price
plus
the premium.
For
the put
option,
the breakeven
level
equals
the
strike
price
minus
the premium.
Simple Mechanics
of Option
Trading
Merchandisers
and, to
a
lesser
extent,
producers
are familiar
with
the advantages
of hedging
with
commodity
futures.
The development
of
options
will
in
ome cases
complement
and
in
thers substitute
for
futures
hedges,
depending
on
the individual's
risk
aversion
and potential
return.
The primary
difference
between
options
and futures
for
hedging
purposes
deals with
the price
that
is locked
in.
A futures
hedge
allows
the hedger
to
lock in a specific price
for the futures,
while
use of
options locks in
a floor
or ceiling
price for
the
futures.
An
uncovered
cash
position
is
characterized
by
having
the potential
for
high
risk
and,
at
the
same time,
large returns.
When
a futures
position
is aken
opposite
to
the
cash posi-
tion,
the
hedger
offsets
potential
cash
market losses
but
can
also negate
any
cash
market
gain.
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With the use
of
options,
losses
in
he cash market
are offset
by
gains
in
he option
market
but
gains
in
he cash
market
are not
negated by
losses
in
he futures
or options.
There
are four
basic
positions in
ption
trading:
buying
puts,
buying calls,
selling
puts,
and selling
calls.
It
should
be
noted
that
puts
do
not
offset
calls
and vice
versa;
each
is a
separate type
of
option. Each option
position
depends
on
the
user s
cash
position along
with other factors
specific
to
each merchant.
long
option
position involves
limited
risk
and potentially large
returns.
Conversely,
a short
option position,
or selling
options,
entails
potentially
large
risks
and
limited
returns.
Buying
Puts
hedger with
a long
cash position
can establish
a loor
price and be
able
to take
advantage of a price rise
by having a
long put position.
The
only cost
involved is
he
premium
paid by the
purchaser to
the seller
at
the time
the transaction
is
initiated. The following
example
will
help
illustrate this.
long
cash grain
position is aken
at a futures
price
which would realize
a
small profit. The
merchant
or
producer
is
ptimistic
about prices
in
he future, yet
he
would
like to
lock in his
price
as a
floor, resulting
in a
small
profit over
operating costs.
The appropriate
action
in he option
market would be to buy puts. This allows
the merchan-
diser to
lock
in a loor
price
equal
to
the strike
price minus
the
premium.
The basic idea
behind this plan
is hat if rices decline
further, the
option
may be exercised to
obtain
the floor price.
Exercising
the put
options involves
assuming a short
futures position at
the
strike
price
when
their
actual
value
is
ess
than the
strike price.
The difference between
the
two
prices
minus
the
premium would be
the net profit. Alternatively,
if he underlying futures price rises,
the puts will not
be
exercised;
the
effective price
will be the higher cash price minus the
premium.
Buying
Calls
long
call position
allows
a hedger to
establish a ceiling price
while being able to benefit from a
price
decline. short cash grain posi-
tion
can be
protected
by
purchasing
call options. Once again, the only
cost incurred is
he premium. number of different scenarios
can be
deve-
loped to illustrate
a short cash position; in ome
cases
price risk will
be
prevalent and in thers quantity risk may be apparent. Specific
examples
of each
will be
given later.
An
illustration of
a short
cash position
will
demonstrate the simple
mechanics of a long call
position.
For instance,
a
merchandiser
or
processor) who
has
sold cash
grain
for future delivery
but does
not
have
the
physical
commodity
on hand
is
subject to
the
risk
of a price
increase before actually
buying
or
pricing
the
grain. The
merchant could hedge in the
futures market but
would not
be
able to
benefit
if
prices declined.
Purchasing
calls
would
lock
in a
ceiling
price equal
to
the strike price, plus, if prices
increased, the
merchant
would be able to
realize
the
ceiling
price by
exercising
the
call
option. This would entail
assuming a long futures position
at the
strike
price when actual value
is
greater;
the difference between the two prices
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less
the premium
will
be the
net
profit.
Conversely
if
rices
fell
the
calls
would
not be
exercised;
the effective
purchase
price
would
be the
cash
price
plus
the premium.
Selling
Puts
Long
option
contracts
are
analogous
to buying
price
insurance
with
the cost
of
the insurance
being
the
premium.
Selling
option
contracts
can
then
be thought
of as
selling
or
writing
price
insurance.
The
option
writer
or
seller
receives
a
premium
in
eturn
for issuing
the insurance.
Consequently
the
option
seller
may
be
able
to
augment
his
income
by the
amount
of
the
premium.
However
the seller
must
also
be
prepared
to face
margin
requirements
and
the possibility
of a
mandatory
futures
position
if
prices move
against
him.
merchant
with a
short
cash
or forward
position
could
sell
puts
with
the
intention
of increasing
income
by
the amount
of
the premium.
This
alternative
is ttractive
only if rice
expectations
are
bullish
or
neutral
because
if
rices
decline
the
futures position may
be assumed
at
a
loss. This
is
he
negative aspect
of selling
puts.
The level
of
gain
from such
a strategy
is ixed
while
the
amount
of
loss is
nlimited.
The
primary
decision
criteria
for
selling
puts is
he premium
value
or
the
maximum
amount
that
can be added
to income.
The basic
mechanics
of selling
puts
to
increase
income
are relatively
easy
to
understand.
The
merchant
begins with
a short
cash
position
as
mentioned
earlier.
He
is
ullish
about
the future
and
feels
that
premiums
are
high enough
to support
selling
put options.
The
merchandiser
receives
the premium
right
away
but he must
also
comply with
margin
requirements.
If prices
go up
sufficiently
the
puts
are
not
exercised
by the
buyer and
the merchant
gains
the premium.
If rices
go down
the options.may
be
exercised
and
the merchant
will
be
assigned
a
long futures
position
at the
strike
price.
In
addition
to
augmenting
income
selling
of puts
can
be used to
acquire
commodity
futures
at a price
below
the
current
market price.
This
will
occur
if
he
put
is
xercised
by the buyer;
the put writer
is
hen
obligated
to
acquire a
long futures
position.
The effective
price
paid
for
the
futures
will be the
put
strike
price
less
the premium
received.
This
type
of
strategy
may
be beneficial
to a merchant
such
as a grain
processor
whose
product
price is
ixed
and
who wants
to protect
his profit
margin.
Selling
puts
offsets
an
increase
in rain
prices
by
the amount
of
the premium
and at
the
same
time
establishes a
loor price
for the
purchase
of
the
grain should prices decline.
It
should
be
noted that
if
prices
do
decline
and the
puts are exercised
the
put writer
can
immediately
offset
his
long
futures
position
by selling futures
for the same delivery
month.
Selling
Calls
The fourth
basic
option
position
is selling
calls.
This strategy
may
be
used by
a
commercial
merchant or
producer
who
has
a long cash position.
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6
A
short
call
position would be taken if e had essentially bearish or
neutral expectations
about
the
particular
grain
market.
Like
selling puts,
selling
calls gives
the
merchant
the
opportunity to increase current income
or
margins
by
the amount of the
premium.
The
scenario
under which calls may
be sold
is asically when a
merchant
has
a
long cash
position
and
expects
the
market
to be
bearish
or
neutral,
as mentioned
above. When
the merchant sells
the
calls,
the
pre-
mium
is arned. Once again, he must also face margin requirements,
including possible margin calls if
he options are
exercised
and
prices
move against
him. If owever, prices fall or
remain
at approximately
the
same
level
over
the life of the contract, the
calls
will
expire.
Consequently,
the merchandiser will be
successful
in
increasing
income by
the option
premium less
depreciation if he
physical grain was
being
stored.
If
prices
appreciate significantly
during the life of the option,
the
calls would
be exercised. This
would
result
in
he
merchant being obli-
gated
to
take a short futures position
at
the
strike
price
when they are
actually valued higher.
The difference between
these two
prices
plus the
premium would result in he net loss. If he
physical grain were being
stored,
the merchant
would also realize an appreciation
in
he
value
of
the
inventory. Thus,
a ceiling price
would be
locked in
or
the commodity.
Summary
on
Use
of Options
Versus Futures
Options and
futures are inherently
related.
This
is vident by the
fact that, like
futures, there are two
basic
option
transactions
which
can
be
initiated.
One is o purchase options
and the
other is o sell or
write
options.
The specific
direction will be
determined by the
user s main
objective.
If
e
wants
to
lock
in a
floor
or
ceiling
price,
the
appropriate
action would be
to
buy options.
The
primary
characteristic
of
this strategy is
nlimited
profit potential
with the only cost
being
the
premium.
Alternatively if is
goal is
o
increase
income,
options
can
be
sold.
However, there would be
unlimited risk of
an adverse
price move,
while the gain
would
be
limited to the
premium.
Therefore, the
risks are
greater and
the
potential return
smaller
with a
short options
hedge
rela-
tive to
a long options hedge.
Table
1 summarizes
the
characteristics
of options
versus
futures
hedges
for
producers and
merchants
with
long
and
short cash
positions.
Typically,
a long
cash
position could
be hedged
in
he
futures
market
by
selling
futures contracts.
This
requires
margin money and,
in ddition,
locks
in the sale
price so
futures prevents
the hedger
from
benefiting
from
a
price increase.
However a
long
cash
position could also
be
hedged in
the
options
market either
by purchasing puts
or selling
calls.
Buying
puts
allows
the
user
to lock in
a floor
price equal
to the strike
price
minus
the
premium. Selling calls
results in an
increase
in
income
by
the amount
of the
premium although
margin
money is
required and
unlimited risk of
a
price
decrease is
realized. In
addition
if
the
underlying futures
price
increases
so
that
the calls
are
exercised the
seller
will
be
obligated to
take
a short
futures
position at the
strike
price when
they are actually
valued higher.
7/24/2019 Aplications Using Options
11/50
T BLE
1.
MERCH NT
C SH
POSITIONS
ND
USE OF FUTURES
ND
OPTIONS
Cash Position
Traditional
Futures
Positions
Alternative Option
Positions
Long
Cash
Sell
Futures
Buy Puts
Inventory
or Forward
Purchase)
requires
margin
protects against price
decrease
cannot
benefit
from
price
increase
locks
in
floor
price
.
benefit
from price
increase
must pay
premium
no
margin
Sell
Calls
increase income
by
amount
of
premium
requires
margin
unlimited
risk
of
price
decrease
possibility
of
having
short
futures
if
exercised
Short Cash
Buys
Futures
requires margin
protects
against
price
increase
cannot benefit
from
price
decrease
locks
in ceiling
price
benefit
from
price
decrease
must pay
premium
no margin
Sell Puts
increase
income
by
amount
of
premium
requires
margin
unlimited
risk
of price
increase
possibility
of
having
long
futures
position
if
exercised
Conversely,
a
short cash
position
is raditionally
hedged
in he
futures
market
by
purchasing
futures
contracts.
Once
again,
this
locks
in
a
price
so the
hedger
is ot
able
to
benefit
from
a price
decrease,
while
Buy
Calls
7/24/2019 Aplications Using Options
12/50
also
requiring
margin
money.
Alternatively,
this
cash
position
could
be
hedged in
he
options
market by
one
of two ways:
buying
calls
or selling
puts.
Buying
calls
locks
in
a ceiling
price.
Selling
puts
increases
income
by the
premium
but requires
margin
money
and exposes
the
hedger
to
unlimited
risk
of a
price
increase.
However,
if rices
decline
signifi-
cantly
and if
he
puts
are
exercised,
the
seller
will
be
required
to take
a
long
futures position
at the
strike price
when
they are
actually
valued
lower.
Application
of Options
by Merchants
and Producers
Traditionally,
elevators,
domestic
merchants
and
exporters
have made
extensive
use
of
the
futures
market
in
edging
cash
positions.
Producers
hold
similar
cash
positions
and the same
principles
apply. The
options
market
can
be used
by any
of these
participants
as a
substitute
and/or
supplement
to the
futures
market
in
he
hedging role.
Each
of these
par-
ticipants
performs
unique
functions
in
he
grain
marketing
chain.
However,
they
are
homogeneous
in
he
sense that
they
can have
similar
cash
posi-
tions.
This allows
for
generalizations
across
merchants
and
producers
about
the type of
option position
to use for
a
specific
cash
position.
A
number
of
assumptions
are
used
in ach
of the
examples
and are listed
below.
Assumptions
used
in
ll
examples:
The
purchase
or
sale
of
an
option
will be
made
at a strike
price
which
is t-the-money.
Premiums are
based
on Black/Scholes
model
calculations
and
are
representative
for
example
purposes.
Options
contracts
are
liquidated
or
offset
in ach case
instead
of
exercising
or letting
them
expire.
There will
be no change
in he basis.
This
is
ssumed
to
demonstrate
the
mechanics
and
isolate
the
effects
of
changes
in
cash
futures
and option values.
There will
always
be some
basis
risk,
and options
do not
protect
against
basis risk.
Long
Cash
For a
erchant with
a long cash
position,
the greatest
risk
is he
price risk
associated with the sale
of
that
grain.
A producer
has similar
risk
when planting
decisions
are made.
The
only difference
between
a pro-
ducer s
and merchant s
cash position
is hat
before
harvest the
producer
also has
an element of
risk
associated
with production
i.e., yield
risk).
Both participants have
a
desire
to
protect
the
value
of
their cash market
position.
When the futures
market
is
used, a futures
price is
locked
in
thereby minimizing
risk.
However,
they
would
be unable to benefit
if
futures
prices increase
after
the
futures
position
is
taken.
This is where
an
options
contract
would
be
desirable.
As
demonstrated
in Table 1
merchants
or
producers
with
long cash
positions
can
either
buy
puts
or
sell
calls. Examples
of each
are described
below.
7/24/2019 Aplications Using Options
13/50
Long Cash/Long
Puts:
A merchant
or producer
with
a
long cash
position
who
wants
protection
against
a bearish
price
move
could
lock in
a floor
price
but
also
benefit
from
a
potential
price
rise
by purchasing
put options.
The
buyer
must
decide
whether
to buy
in-the-money
(ITM), at-the-money
(ATM),
or out-of-the-money
(OTM)
puts, although
we are
assuming
ATM
in his
case
(the
differences
will be
discussed
in
reater
detail
later).
The
premium
will
vary
for each
case
as will the
final
results.
long
put
position
gives
the
uyer
the
right
ut not
the obligation
to
sell futures
at a specified
strike
price
or
exercise the option.
However,
instead
of
either
exercising
or letting
the option
expire,
the buyer
may also offset
his
position
by selling
the
puts
back.
The
price
movement
of
the
underlying
futures price
will
affect
the
buyer s
decision.
If he
underlying
futures
price
increased
signifi-
cantly
over
the life
of
the
option,
the
buyer could
then
either
let
it xpire
and
realize the
greater price
or
sell
the
puts
back
and
possibly
earn
a
premium
plus the
higher
cash
price.
If he
opposite
occurred,
that
is
he
underlying
futures
price
dropped considerably,
the
buyer
could
again pick
one
of
two
possibil-
ities:
exercise
the
option
and be
given
a
short futures
position
at
the
strike price,
or offset
the
option,
receive
a
premium,
and
be out
of the
futures
market completely.
In ither case,
the
risk is
limited
to the
premium paid
while
the
possible
returns
are
unlimited.
The
mechanics
of this
type
of transaction
are best
illustrated
in
Example
1.
Example
illustrates
that
the
largest net
result occurs
when the
underlying
futures
price
increases It
hould
e
noted
that
the
premium
earned
on the liquidation
of
the puts
is qual
to
zero
because
there
is
o
intrinsic
or extrinsic
value left
in
he
option.
Conversely,
when the
underlying futures
price
declines,
the intrinsic
value
of
the
puts increases
and results
in
he greater
premium being
earned from
offsetting
the position.
However, the net
result
is
still a negative
figure
because the
intrinsic
value did
not increase
enough
to
cover both the
cash
loss
and
the
original
premium.
Thus,
the returns
have
unlimited
upside potential
while the
largest
loss is
limited
to the
premium.
A traditional
hedge against
a
long
cash position
would
be
to sell
futures.
In
Example
1
because
the
basis
is
assumed unchanged
the
net
result
would
be zero
and the effective
sales
price would be
410.
Thus
if
prices increase
an options
position
is preferable
to
a
futures
hedge
and vice
versa
for price decreases.
7/24/2019 Aplications Using Options
14/50
-
1
-
EXAMPLE
1 LONG CASH LONG
PUTS
Setting:
September
3
984
Buy 20,000 Bushels
@410
December
Futures
380?
Duluth
Basis
30O
December 380
Put
8?
A.
ell cash
on November
1 at which
time
December
futures
increased
to 4209.
Basis
is
nchanged
at
30 .
1. ell
offset)
put, or let expire
2.
Calculation
of
returns
Return from
cash sale 450?
Less purchase price
-410
Less
premium
paid
- 8
Plus premium earned
0
Net
Result
9
Effective
Sale
Price
442?
B.
ell cash
on
November
1 at
which
time
December
futures
decreased
to 350.
Basis
is
nchanged
at
+30.)
1.
Could
exercise
option,
or
sell
offset)
put
2. Calculation
of returns
Return
from cash sale
380?
Less purchase
price
-410
Less
premium
paid
-
8
Plus
premium earned
30
Net
Result
- 8
Effective Sale Price
402?
Long Cash/Short Calls:
Another
tactic
for
a
merchant or producer
with a long cash
position
is to sell
call options
A short call
position
allows the
seller
to
augment
current
income
by the
amount
of
the premium This
course
of
action is
especially
attractive
if
prices are
expected
to remain
relatively
stable
7/24/2019 Aplications Using Options
15/50
Once
again,
the
ITM, ATM,
or OTM
calls
can be
sold,
but it
is
assumed
that
ATM
calls
are
used.
In
his
case,
the
seller
receives
the
premium
at
the
time
of
the sale.
The return
is
imited
to
this
premium
while
potential
losses
are
unlimited.
Margin
money is
lso
required
to
cover
a potential
futures
position.
short
call
posi-
tion
does
not offer
the
seller
many
alternatives
in egard
to
a
price
increase
or decrease.
The
only
choice
is
etween
holding
the
call
position
with the results
determined
by the actions
of
the
buyer
or
buying
the
calls
back
before
they
are exercised
or expire.
If
he
underlying
futures
price
increases,
the
buyer
may
exercise
the calls,
in
hich
case
the
seller
will
be
given
a
short
futures
position
or
the
seller
can
offset
the
calls
before
they
are
exercised
to
ensure
staying
out
of the
futures
market.
However,
the
seller
must
remember
that
if
e offsets
the options,
he will have
to pay
a premium.
If
the opposite
occurs
where
futures
prices
decrease,
the buyer
will
most
likely
not exercise
the calls
because
the
price
move
is
favorable.
The
seller
can
then
buy
the
options
back
any
time
before
expiration
if esired,
or he
could
simply
let them
expire
without
liquidating.
Example
illustrates
the mechanics
of
this
type
of
transaction
when the
options
are
offset.
It
is
vident
from this
example
that
the greatest
possible
net return
is limited
to
the premium
earned
from
the
call
sale,
which
in
his
case
is
8 cents.
Furthermore,
the seller s
risk is
heoretically
unlimited.
When
the futures
price
did decline
and
the calls
were
offset,
the premium
paid
was
equal
to zero
because
the option
had no
intrinsic
or extrinsic
value
left.
However,
in
art A
where
the
futures
price
increased,
the
options
gained
intrinsic
value
and thus
resulted
in
he 40-cent
premium
paid
for
offsetting
the calls.
Therefore,
selling
call
options with
the
intention
of
later
liquidating
this
position
is isky
and
is eneficial
only when
futures
prices
remain
relatively
stable
or
increase.
Summary
of Long
Cash Position
A merchant
or producer
with a
long cash
position
has two option
alternatives:
to buy
puts
to
lock ina
floor price,
or
to sell calls
to
supplement
current
income.
An
important
difference
between
the
two choices
is
he risk
levels
involved.
Buying
puts
is
referable
to traditional
hedging
if
utures
prices
increase
because
the gain
in
ash prices
is
ot
offset
by losses
in
he futures.
long
put position
results
in
imited
risk
and
unlimited
profit potential,
while
a short
call
position
is
harac-
terized
by a
return
limited
to
the premium
and
risk that is
heoretically
unlimited. Thus
in
most hedging applications buying puts
will be
more
advantageous
than selling
calls.
Short
Cash
Another
typical position
of
grain merchants
processors
and
to
a
lesser
extent
producers
is
to be
short
cash
grain.
If
a
futures
market
is used as
a
hedge
the purchase
price
is locked
in
so
long
as
the
basis
is
7/24/2019 Aplications Using Options
16/50
-
12
-
EXAMPLE
2
LONG
CASH/SHORT
CALL
Setting:
September
3 1984
Buy 20 000
Bushels @410
December Futures
8 ?
Basis
3
December 380
Call 8?
A
Sell cash on November 1 at
which time
December futures increased
to 420.
(Basis is
unchanged
at +30 .)
1
Buyer
may exercise calls,
or seller may offset
(buy
back)
the call
2. Calculation of
returns
Return from cash sale 450?
Less
purchase
price
410
Option premium
earned
8
Less premium
paid -
40
Net Result
8?
Effective Sales
Price
418?
*Loss in ption
is
ffset by gain
in
ash
value.
B
ell
cash
on
November
1
at
which time
December futures decreased
to
350.
(Basis is nchanged at +309.)
1 ption will
not
be
exercised y purchaser
2 Calculation
of returns
Return from
cash sale
380?
Less
purchase
price
-410
ption
premium earned
8
Less premium paid
0
Net Result - 22?
Effective Sales Price 388?
unchanged.
However the merchant
is
unable
to take advantage
of
a decrease
in prices
after
the
contract
is
made.
An options hedge
on
the
other hand
permits
the buyer to benefit
from
a price
decline.
7/24/2019 Aplications Using Options
17/50
3
A merchandiser
with
a
short
cash
position
would
ultimately
like
to
establish
a ceiling
price
and take
advantage
of a
fall
in
rices.
A common
scenario
is or
a
erchant
or
processor
to sell
grain
for some
future
month
but
not
have
the physical
grain
on hand.
Purchasing
call options
would
establish
a ceiling
price
for
the
eventual
cash
purchase.
Merchants
can
either
buy
calls
or
sell
puts
against
a
short
cash
position.
The
following
examples
illustrate
the
mechanics
involved
and
possible outcomes.
Like
the
first
examples
the same
assumptions
apply.
Short
Cash/Long
Calls:
A merchant
or producer
with
a short
cash
position
who
wants
to pro-
tect against
a bullish
price
move
and benefit
from
a
potential
price
decline
could
lock in
a ceiling
price
by purchasing
call options.
It
is
ssumed
that
ATM calls
are
bought
although
ITM
or OTM calls
are
also possible.
The
buyer
pays
a premium
for
the
privilege
to lock
in
the ceiling
price.
The
long call
position
gives
the
buyer
the
right but
not
the
obligation
to buy
futures
at the
strike
price
or
to
exercise
the
call
option.
Two
more
alternatives
still
exist:
he
could
let the
options
expire
or
offset
his position
by selling
the
calls back.
The
decision
depends
on
the
movement
of the
underlying
futures
price.
If he
underlying
futures
price
increased
significantly
the
merchant
could
exercise
the options
in
hich case
he would
receive
a long
futures
position
at
the strike
price
when
the futures
value
is
actually
greater.
Alternatively
the
buyer
could
liquidate
his
option position
gain
a
premium
and
be clear
of the futures
market.
If
he
futures price
declined substantially
the
buyer could either
let
it
xpire
and
realize
the lower
price
or offset
the
calls to
possibly.gain
a
premium.
Furthermore
because
the futures
price
declined
the
purchase
price
will also
be
less.
Example
illustrates
the
mechanics
of
this
type
of transaction.
This example
shows that
the greatest
loss
is imited
to the
premium
paid
while
the
potential
returns
are
virtually
unlimited.
When
the
underlying
futures
price increased
the
net result
was
a loss
of 8
cents--the
premium. The
premium
earned
from the
liquidation
of the
calls just
offset
the larger
purchase
price
because the intrinsic
value of the
calls had
increased.
Conversely
in
art B the premium
earned
equalled zero
because there
was
no intrinsic
or extrinsic
value
left.
The net result
is
greater
in Part
B
because of
the
lower
purchase
price.
Buying
calls
is
preferable
to traditional
hedging
if
futures
prices
decrease because
the
gain
in
the
cash price
is not
offset
by losses
in the
futures.
If
futures
prices
increase
buying futures
yields
a
greater
return by
the cost
of
the premium.
7/24/2019 Aplications Using Options
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-
4
-
EXAMPLE 3.
SHORT
CASH LONG
CALLS
Setting:
September 3
1984
Sell
20 000 Bushels @410
December
Futures
380?
Basis
3
December
380
Call
8?
A
Buy cash
on
November
1 at
which time
December futures
increased
to
420 .
1
ption
can be
exercised,
or sold
to
offset
2
Calculation
of returns
Return
from
cash
sale 410?
Less purchase
price
-450
Less
premium
paid
-
8
Plus
premium
earned
40
Net Result
-
8?
Effective
Purhcase
Price 418?
B
Buy
cash on
November
1 at
which
time December
futures
decreased
to
350 .
1 Option
could
be left
to
expire,
or
offset
2 Calculation
of returns
Return
from
cash
sale
410o
Less
purchase
price
-380
Less
premium
paid
-
8
Plus premium
earned
0
Net Result
22
Effective
Purchase
Price
388?
Short
Cash/Short
Puts:
Buying
call
options
is
ot the
only
strategy
for
a
erchant
or pro-
ducer
with a
short
cash
position.
Put
options
could
also
be sold.
This
alternative
does
not lock
in
a
ceiling
price
however.
Instead
it
either
offers
a
chance
for
the
merchant
to
increase
his current
income
or buy
futures
at a
lower
price
if
the
options
are
exercised.
The
best
outcome
will
occur if
the
market
remains
relatively
stable
7/24/2019 Aplications Using Options
19/50
5
so
that
the options
will not
be exercised,
but
yet
retain some
intrinsic
value.
Furthermore,
the results
will vary
depending
on
whether the
merchant
sells
ITM, ATM,
or
OTM puts;
however, ATM
puts
will
be
assumed
sold.
Selling puts
will
produce
a
limited return
equal
to
the
premium
while the risk
potential
will
be
unlimited.
In
addition,
the
merchant
will
be
required
to have
margin
money
available.
Overall,
a short put position
has
virtually
the same
fundamental
characteristics
as a short
call position.
The
seller
can
only choose
between
liquidating
his position
before the
puts
are
exercised
or
waiting
for the buyer s
actions.
If he
underlying
futures
price
increases,
the buyer
would likely
let the
options expire
because
he
wants
the highest
possible
price. The seller
then
can decide.whether
buying
the
puts
back
or
letting
them expire
will result
in igher
returns.
If he
futures price
decreases, the buyer
would probably
exercise
the
puts,
resulting in he
seller s
assuming a long
futures
position at
the strike price.
However, the
seller could
also buy
the
puts back
before they
are exercised
to
alleviate
entering the
futures
market.
The
procedures
and
outcomes
involved
in a
short
cash/short
put position when
the futures
price increases
and
decreases
are
illustrated in
xample 4 The option position
will be
offset
in oth
instances
to insure consistency
with
previous
examples.
Part
B
of Example 4 shows
that
a
positive
return occurs
when the
underlying
futures price decreases,
and
this
return
is qual
to the
premium
of
8
cents. The merchant
paid 30
cents to buy the puts back
because of
the
gain
in ntrinsic
value. In
ontrast, the
cost of
liquidating
the
short put position
in art A
was
risky
because the
option had
no
intrinsic
or extrinsic value remaining.
It is bvious
that
the reason
the net
result was negative
in art A was
because of
the
greater
cash
purchase
price.
However,
if
ptions
had not been
used at
all,
the
net
result
would
have been
-40 cents.
Conversely,
the outcome
in
art
B
was positive
because of the smaller
cash price.
Thus,
a erchant
selling
put
options
with
the intention
of
later
buying them back accepts a theoretically unlimited
amount of
risk,
while the return
is imited to the premium.
The
premium can
only
be
realized if he futures
price remains relatively stable or
decreases,
however.
Summary of Short Cash Position
The last two
examples have shown
that
a erchant
or
producer with a
short cash position
has
two basic
option
strategies
to
choose from
depending
on his objectives.
If
his main objective
is
to
lock in a
ceiling
price on the
purchase
of
the grain call
options should
be
bought. This
tactic also permits the
merchant
to
benefit from
a
decline
in
grain prices.
Buying
call
options
is
preferable
to traditional
hedging i.e.
buying
futures
if
futures
prices subsequently
decline.
If the
main goal
is
to
augment current
income
or margins
and
prices
are
expected
to be
relatively
neutral
or
slightly bearish
put options
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6
EXAMPLE 4. SHORT
CASH/SHORT PUTS
Setting: September 3
1984
Sell
20,000 Bushels
@410
December Futures
8 ?
Basis 30
December 380
Call 8?
A.
uy
cash on November 1 at
which
time December futures
increased
to 420 .
1. ption could be
left
to
expire, or
offset
by
seller
2. Calculation
of returns
Return from cash sale
410?
Less purchase
price
-450
Premium
received
8
(Sept. 1
Less
purchase
of
put
0
Net Result
32
Effective Purchase Price
442?
B. uy
cash
on November
1 at which
time December futures
decreased
to
350
1. Buyer
may
exercise
option, or
seller may
offset (buy
back)
2. Calculation
of returns
Return
from
cash sale
410?
Less purchase
price
-380
Premium
received
8
Less
purchase
of
put 30
Net Result 8?
Effective Purchase
Price 402?
should
be
sold.
The disadvantage
of
this procedure
is hat
if rices
decrease
and the
options
are
exercised before
they are
offset,
the seller
will
be
required
to take a long
futures position
at
the strike
price
when
the actual
value
is less.
Again, the
greatest
difference
between
buying
calls
and
selling
puts is the
risk level
involved.
Purchasing
calls
results
in a limited
risk the
premium)
and
unlimited returns.
Selling
puts,
on the other
hand,
is
characterized
by
theoretically
unlimited
risk,
with only
limited
returns
the
premium).
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7
Forward
Contracts
With
Floor
and
Ceiling
Prices
The
options
market
has
the
possibility
of
giving
a new
dimension
to
forward
contracts.
Typically,
forward
contracts
have
been
made
by
elevators
to producers,
by exporters
to importers
and
by merchants
to
processors.
In
he past,
these
types
of
contracts
have
been
implemented
via the
futures market.
The
result
has been
a
forward contract
with
a
fixed
price.
The disadvantage
of
this
situation
is
hat
a
producer
would
be unable
to benefit
from
a rise
in rices
or an
importer
unable
to
take
advantage
of
a
fall
in
rices.
Agricultural
options
stand
to change
this
scenario
by making
forward
contracts
more attractive
to producers
and end
users.
Merchants
can
offer
a
forward
contract
with
a
floor
or ceiling
price
by
incorporating
the
use
of options.
The logic
behind
this
plan
is
asy
to
understand
because
it
ollows
from
previous
examples.
For
instance,
an
elevator
can
lock
in a
floor
price
for
its
own grain
sale
by purchasing
put
options
and then
pass
this
floor price
on
to producers
through
a forward
contract.
The cost
of the
put
options,
or the premium,
would
be included
in
alculating
the
producer s floor
price.
Likewise,
a
erchant
can lock
in a
ceiling
price
on
purchases
by buying
call options,
which can
then be
passed
on
to end users
via
a orward
contract.
Once
again,
the
ceiling
price
would
reflect
the
exporter s
cost
of
buying
the calls.
The
mechanics
of
these
transactions
will be
demonstrated
later.
A
number
of advantages
to both
merchants
and their
customers
can
be
realized
by incorporating
options
into
forward
contracts.
The biggest
advantage
to
producers
and
end
users
is hat they
could
lock in
a floor
or
ceiling
price
and
would
be able to
benefit
from a
favorable
cash
price
move;
with
traditional
forward
contracts
they
would
not. Furthermore,
the
new
forward
contract
would
permit
individuals
to take
advantage
of options
indirectly through
the
merchant without
being
directly
involved
in
he
option market
or
understanding
the mechanics
themselves.
Merchants
will
benefit
from
this
new concept
as long as
their
customers
make
use
of the
program.
This is
vident
because
the merchant s
return
is ependent
on
throughput.
Consequently,
one of
the most
important
advantages
of a for-
ward
contract based
on options
is hat
it ffers
another
merchandising
alternative
and
could
stimulate
additional
grain
handled.
Specific
examples
of
forward
contracts with
floor
and
ceiling prices
are given
below:
Forward
Contracts
with
Floor
Prices:
Forward
purchase
contracts
have typically
been
made
at
fixed
prices.
One
of
the
most
common transactions
with
this
type
of
contract
is
between
an elevator
and a producer.
If the elevator
is doing
a good
job
of
marketing through
the futures market and
reflects
this
in
its
forward
contracts
the producer
need not become directly
involved
in
the
futures
market.
Part A
of Example
illustrates
how an elevator
calculates
the
traditional forward
contract
price and
hedges in the
futures
market.
7/24/2019 Aplications Using Options
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-
18
-
EXAMPLE
5.
DERIVATION OF FORWARD
PRODUCERS) WITH PRICE FLOOR
CONTRACTS
FOR
PURCHASE
(I.E., TO
Setting:
September
3,
984
December Futures
Basis (Terminal Market)
Trans.
and
Handling
December
380
Put
38 9
9
9
A.
Derivation
of conventional
forward contract
price:
selling December
futures
Calculation:
December
futures
3809
Basis
+30
Trans. and
handling
-50
Producer Price
3609
Hedge
by
B.
Derivation
of forward
contract
prices
options
Calculation:
Strike
Price
Basis
Trans.
and handling
Less put premium
Producer Price
1. If
a
b
with price floor
380O
30
-50
-8
35 9
December
futures increase to 420
by
November
1
Option
will
not be
exercised
but
will be offset
Derivation
of producer
price:
December
futures
Basis
Trans.
and
handling
Less
option
premium
(Sept.
3
Plus
option value
(Nov. 1
Producer Price
4 9
30
50
8
0
392
December
futures
decrease to 350 by
November 1
Option
can be
exercise,
or
offset
Derivation
of producer
price:
December futures
3509
Basis
30
Trans.
and
handling
-50
ess option
premium
- 8
Sept. 3
Plus option premium
Nov. 1
Producer Price
30
352?
Buy put
2. If
a
b
_ __
7/24/2019 Aplications Using Options
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9
This type
of contract
allows
the
producer
to
lock
in a
sale
price
of
3.60.
The
disadvantage
of
this
contract
is hat
the
producer
cannot
benefit
from
a
rise
in
rices.
The use
of
options
will
alleviate
this problem.
forward
contract
with
a
floor
price
can
be
offered
if
he
merchant
incorporates
put
options
into the
scheme. Part
B
of
Example shows
how this
floor
price
is
erived
and
the
consequences
of
a
change
in
the
underlying
futures
price
over
time.
It
hould
be
noted
in
he
following
examples
that,
once
again,
the option
positions
are
assumed
to be offset.
In his
example,
the
merchant
purchased
at-the-money
put
options
at
a
premium
of 8
cents.
It
is
emonstrated
that
the floor
price
quoted
to the
farmer
is
ess than
the
flat
forward
contract
price
by
the
amount
of this
premium.
Thus,
the
put
premium
will affect
the
attractiveness
of
the
price
floor
contract.
f the
underlying
futures
price increased
over
the
life
of the
contract,
the
merchant
could
either
let the
option
expire
or
liquidate
his
position.
It
is
ssumed
the
position
is iquidated;
however,
there is
o
intrinsic
or extrinsic
value
left
in he
option
so the
merchant does
not receive
a
premium
on the
sale.
The
merchant
does
realize
the greater
future price,
which
is assed
on
to
the pro-
ducer.
Consequently,
the
producer
received
3.92 with
the
price
floor
contract rather
than
3.60
under
the
conventional
forward
contract.
If he futures
price
decreased,
the
merchant
could
have
exercised
or
offset
the
option.
Once again,
it
is
ffset.
The
merchant
does
receive
a
premium of 30
cents
on the sale
in his
case,
because
the
option
has
gained intrinsic value.
However,
this
is
iscounted
by
the
futures
price
decline. The
end result
is hat
the producer
realized
the
floor
price.
Forward
Contracts
With
Ceiling
Prices:
Traditionally
domestic and
export
merchants have
offered forward
sales
contracts
at
fixed
prices. The
futures
market is
n important
component
in
etermining
the specific
price.
Part
A
of
Example
6
demonstrates
how
the conventional
forward
price is
erived
and the
appropriate futures position taken.
This
type
of
contract
is
appealing
to buyers, such
as importers,
if
hey can establish
prices
for deferred delivery.
However
by doing so,
they
do not benefit
from
price
reductions.
Options
give
merchants
the opportunity
to change
the
typical forward
contract.
A
merchant
could offer
a forward
sale
contract
with
a
ceiling
price by purchasing
call
options.
The
mechanics
are iden-
tical to
the earlier example
of
a
merchant
with a
short
cash
posi-
tion.
By
purchasing
calls
the
merchant
locks in a ceiling
price
and
can
pass
this
on to
his
customers
via a
forward
contract.
The
only
7/24/2019 Aplications Using Options
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2
EXAMPLE
6. DERIVATION
OF
FORWARD CONTRACTS
FOR SALE
(E.G.,
TO
IMPORTERS)
WITH PRICE CEILING
Setting:
September
3, 984
December
Futures
3809
Basis (Terminal
Market)
30O
Trans. and Handling
50O
December
380
Put
A. Derivation
of
conventional forward contract
price: Hedge
by
buying
December futures
Calculation:
December
futures 380O
Basis +30
Trans.
and
handling
+50
Offer
Price
460
B. Derivation
of
forward
prices
with
price
ceiling:
uy
call
options
Calculation:
Strike
price
3809
Basis
30
Trans. and handling +50
Less
put
premium + 8
Offer
Price
468
1. If ecember
futures increase to 420
by November 1
a
Option
can
be
exercised or offset
b
Derivation of
importer price:
December
futures
420
Basis
30
Trans. and handling
+50
Plus
option
premium + 8
(Sept. 3
Less option
value
-40
(Nov. 1
Effective Purchase
Price
468
2. If ecember futures decrease
to
350
by
November 1
a ption will not be
exercised, but is ffset
b Derivation
of importer price:
December futures 3509
Basis
30
Trans
and handling
+50
Plus
option premium
+ 8
Sept.
3
Less option
premium 0
Nov.
1
ffective
Purchase
Price 438B
7/24/2019 Aplications Using Options
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2
stipulation
is
hat
the cost
of the calls
is
lso
passed
on
to
the
customer,
built
in
o the
ceiling
price.
Importers,
as
well
as other
end
users,
should
find
this
contract
more
appealing
because
they
can
still
take
advantage
of
a price
decline,
and
it
llows
them to bene-
fit
from
options
without
actually
trading
them.
The
calculation
of
the forward
ceiling price
is emonstrated
in
Part
B
of Example
along
with
the results
of
an
increase
and
decrease
in
he underlying
futures
price.
The merchant
bought
at-
the-money
call
options
for
a premium
of 8
cents.
The ceiling
price
is
hen
greater
than
the
flat
price
by
the amount
of
this
premium.
If he
underlying
futures
price
increases,
the merchant
has
two
alternatives:
exercise
or
offset
the
option.
For
the sake
of con-
sistency
it is gain
assumed
that
the calls
are
liquidated.
The
increase
in
he
underlying
futures
price
results
in a gain
in
he
option s
intrinsic
value,
which
is eflected
in he
40-cent
premium
earned
on
the
call
sale.
This
premium
offsets
the
rise
in
he
futures
price
and
is
assed
on to the
importer.
Consequently,
the
price
realized
by the
importer
is
qual
to
the
ceiling
price origi-
nally
quoted
to
him.
If instead
the futures
price decreases,
the merchant
again
has
two
possibilities:
to
let
the option
expire
or
offset
his position;
the
latter
was chosen
here.
The
option s
value drops
to
zero
because
of
the
decline
in
he futures
price
so no premium
was
recovered
on the
liquidation.
However,
because
of
the
flexibility
of
options, the
merchant is ble
to
pass
the lower
futures price
on
to the buyer.
Thus,
the
buyer must
decide
if
ocking
in a
ceiling
price that
is
greater
than a flat
forward
price
is
orth
the
benefits
received.
The
conventional
forward
contract
is
ore
beneficial
if rices
do
rise,
but isa riskier
alternative.
Summary
of Forward
Contracts
A forward
contract
with
a floor
or ceiling
price
built-in
is a
new
marketing
concept,
the
success
of
which
depends
on
the conceptual
understanding
by
merchants,
the premium
values, and
effective
prices
relative
to farm programs
prices.
Country
merchants
can offer
producers
an
array of
marketing
alternatives
ranging
from fixed
price
to various
floor
price
contracts. Similarly,
merchants could
offer
end
users
an array
of
marketing
alternatives
ranging
from
fixed price
to various
ceiling
price
contracts.
The
primary advantage
of
incorporating
options
into forward
contracts
is
that both
the
customer
and
the
merchant
can lock
in a
floor
or
ceiling
price, which
not
only allows
the customer
to
benefit from
options
without
direct involvement
in
the options
market
but
also could attract
business
for the merchant.
There are
additional types
of marketing
situations
in
which merchants
may incorporate
options,
but the
fundamental
positions
will
be
similar.
Specifically,
traditional
forward
contracts
have
characteristics
similar
to no-price-established
NPE) and
basis
contracts
although
the latter
have ulterior
advantages.
Thus, options
may
also prove
useful
in
augmenting
other
conventional
marketing
plans.
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Quantity
Risk
Another
viable
use
of
options
is
o hedge
against
quantity
risk.
Many
merchants
make
cash
transactions
after
the
futures
exchanges
have
closed
and
when the
exact
quantity
is
nknown.
Consequently,
there
is isk
between
the
cash
transaction
price
and the
next
day's
price
when
the
hedge
is laced.
A solution
to this
problem
would
be
to buy
options.
Another
type
of
quantity
risk
is
haracterized
by
a
grain
merchant's
having
ten-
dered
an offer
to sell
grain
overseas
but
not
knowing
for
several
days
whether
the
offer
will
be
accepted.
During
this
time
the price
of the
com-
modity
could
move
up
or down.
If he
exporter
had
hedged
in
he futures
market
by
purchasing
futures
and
the offer
was
rejected
after
the
price
of
the
commodity
had
fallen,
the
merchant
would
be subject
to a
loss in
he
futures
market.
By
purchasing
call
options
instead,
the
exporter
would
have
ensured
that
if he offer
was
rejected,
his
loss would
be limited
to
the
premium.
Producers
are
also
exposed
to quantity
risk
in reharvest
hedging.
Indeed,
perhaps
one
of
the
hindrances
detracting
producer
use
of
futures
for
hedging
is
uantity
or yield
risk.
As
an
alternative,
pro-
ducers
could
use
options
as a hedge,
which
in ome
cases
is
ore approriate
when
quantity
risk
exists.
The
examples
below
illustrate
the
mechanics
of the use
of
options
where quantity
risk
exists
and are
referred
to
as Overnight
Transactions.
Overnight
Transactions
Example
demonstrates
the
mechanics
of
an overnight
transaction.
The main
feature
of
this
example
is
a merchant's
making
an offer,
which remains
valid for
five
days,
to sell grain
at
$4.10
per
bushel.
To hedge
this
tender,
the
merchant
buys
at-the-money
call options
at
a
premium
of 8
cents.
The
merchant
does this
because
he
wants
to
establish
a ceiling
price
so that
if
he offer
is
ccepted
and prices
rise,
he
can
still
profit.
Likewise,
he
wants
to limit
his losses
if
the
offer
is
ejected
and
prices
fall. Whether
the
offer
is ccepted
or rejected,
however, the returns
will depend
on
the
movement
of the
underlying
futures
price.
Scenarios
are then
given
for offers
that
are
accepted
and rejected.
Part
A
of Example
illustrates
that if
he offer
is
ccepted,
the
merchant
effectively
has a short
cash/long
call
position. Therefore,
the
returns
realized
when the
underlying futures
price
increases
and
decreases
can
be calculated
using
the same mechanics
as in
revious
short
cash/long
call
examples.
Part
B shows the
effects
of
a
futures
price
increase
and
decrease
when
the
offer
is
rejected.
It is
apparent
that the greatest
return
Recommended