OPTIONS: HEDGING

1
OPTIONS HEDGING

• Short (or Selling) Hedge
• Protects from FALL in spot price
• Locks in a SELLING FLOOR price
• Long (or Buying) Hedge
• Protects from RISE in spot price
• Locks in a BUYING CEILING price

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OPTIONS SHORT HEDGE

• SPOT MARKET OPTIONS MARKET
• ACTIVITY ACTIVITY
• NOW Committed to sell Buy PUTs
• (Long in spot) (Right to be short in
• futures)
• LATER Sell commodity Sell back PUTs, or let
• (Spot position PUTs expire cleared)
  (PUT position
• cleared)

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OPTIONS SHORT HEDGE

• PUT Strike
• -
• PUT Premium
• Expected Basis
• Expected Selling FLOOR Price

4
EXAMPLE of Short Hedge with Options CORN
PRODUCER

• It is April 2002. You are about to plant corn.
• Current December futures price is 2.19/bu.
• Basis in mid-November has been
• 0.32/bu (in 2001), 0.30/bu
  (in 2000)
• 0.33/bu (in 1999), 0.36/bu
  (in 1998)
• under December, so your predicted basis is
  0.33/bu under December.
• Expected spot price for mid-November 2002
• 
  1.89/bu ( 2.19 0.33)

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EXAMPLE of Short Hedge with Options CORN
PRODUCER

• December Current
  Expected Expected
• PUT December November
  Selling
• Strike PUT
  Basis FLOOR
• Premium Price
• 2.00 0.07 -0.33 1.60
• 2.10 0.11 -0.33 1.66
• 2.20 0.16 -0.33 1.71
• 2.30 0.22 -0.33 1.75
• 2.40 0.29 -0.33 1.78

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EXAMPLE of Short Hedge with Options CORN
PRODUCER

• Scenario 1 Futures FALL from 2.19 to 2.00
• SPOT PUT BASIS
• ACTIVITY ACTIVITY
• APR. Expected Buy Dec. 2.40 strike Expected
  -0.33
• Floor 1.78/bu for 0.29/bu
• NOV. Sell 1.67/bu Sell back for 0.40/bu Actual
  -0.33
• Spot Price PUT Gain/Loss Net Selling
  Price
• 1.67/bu 0.11 1.78 (as
  expected)

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EXAMPLE of Short Hedge with Options CORN
PRODUCER

• Scenario 2 Futures RISE from 2.19 to 2.60
• SPOT PUT BASIS
• ACTIVITY ACTIVITY
• APR. Expected Buy Dec. 2.40 strike Expected
  -0.33
• Floor 1.78/bu for 0.29/bu
• NOV. Sell 2.27/bu Sell back for 0/bu Actual
  -0.33
• Spot Price PUT Gain/Loss Net Selling
  Price
• 2.27/bu (-0.29) 1.98 (as
  expected)

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EXAMPLE of Short Hedge with Options CORN
PRODUCER

• December Expected Net
  Selling Price
• PUT Selling (Nov. spot
  (Nov. spot
• Strike FLOOR
  1.67/bu) 2.27/bu)
• Price
• 2.00 1.60 1.60 2.20
• 2.10 1.66 1.66 2.16
• 2.20 1.71 1.71 2.11
• 2.30 1.75 1.75 2.05
• 2.40 1.78 1.78 1.98

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OPTIONS SHORT HEDGING

• Many possible FLOOR prices
• (must pick right one for you)
• Note
• Actual FLOOR ? expected FLOOR
• only if
• Actual Basis ? expected Basis

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OPTIONS LONG HEDGE

• SPOT MARKET OPTIONS MARKET
• ACTIVITY ACTIVITY
• NOW Committed to buy Buy CALLs
• (Short in spot) (Right to be long in
• futures)
• LATER Buy commodity Sell back CALLs, or
• (Spot position let CALLs expire cleared)
  (CALL position
• cleared)

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OPTIONS LONG HEDGE

• CALL Strike
• CALL Premium
• Expected Basis
• Expected Buying CEILING Price

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EXAMPLE of Long Hedge with Options SOY PROCESSOR

• It is April 2002. You will buy soybeans in late
  October.
• Current November futures price is 4.63/bu.
• Basis in late October has been
• 0.29/bu (in 2001), 0.35/bu
  (in 2000)
• 0.44/bu (in 1999), 0.42/bu
  (in 1998)
• under November, so your predicted basis is
  0.38/bu under November.
• Expected spot price for late October 2002
• 
  4.25/bu ( 4.63 0.38)

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EXAMPLE of Long Hedge with Options SOY PROCESSOR

• November Current
  Expected Expected
• CALL November October
  Buying
• Strike CALL
  Basis CEILING
• Premium Price
• 4.20 0.51 -0.38 4.33
• 4.40 0.39 -0.38 4.41
• 4.60 0.29 -0.38 4.51
• 4.80 0.22 -0.38 4.64
• 5.00 0.16 -0.38 4.78

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EXAMPLE of Long Hedge with Options SOY PROCESSOR

• Scenario 1 Futures FALL from 4.63 to 4.25
• SPOT CALL BASIS
• ACTIVITY ACTIVITY
• APR. Expected Buy Nov. 5.00 strike Expected
  -0.38
• Ceiling 4.78/bu for 0.16/bu
• OCT. Buy 3.87/bu Sell back for 0/bu Actual
  -0.38
• Spot Price - CALL Gain/Loss Net Buying
  Price
• 3.87/bu - (-0.16/bu) 4.03 (as expected)

15
EXAMPLE of Long Hedge with Options SOY PROCESSOR

• Scenario 2 Futures RISE from 4.63 to 5.31
• SPOT CALL BASIS
• ACTIVITY ACTIVITY
• APR. Expected Buy Nov. 5.00 strike Expected
  -0.38
• Ceiling 4.78/bu for 0.16/bu
• OCT. Buy 4.93/bu Sell back for 0.31/bu Actual
  -0.38
• Spot Price - CALL Gain/Loss Net Buying
  Price
• 4.93/bu - 0.15/bu 4.78 (as expected)

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EXAMPLE of Long Hedge with Options SOY PROCESSOR

• November Expected Net
  Buying Price
• CALL Buying (Oct. spot
  (Oct. spot
• Strike CEILING
  3.87/bu) 4.93/bu)
• Price
• 4.20 4.33 4.33 4.33
• 4.40 4.41 4.26 4.41
• 4.60 4.51 4.16 4.51
• 4.80 4.64 4.09 4.64
• 5.00 4.78 4.03 4.78

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OPTIONS LONG HEDGING

• Many possible CEILING prices
• (must pick right one for you)
• Note
• Actual CEILING ? expected CEILING
• only if
• Actual Basis ? expected Basis