Hedging Using a Futures Put Option

Hedging with a futures put option is one of the marketing tools that can be used to forward price a commodity to protect against a price movement. The purpose of using this marketing tool is to manage risk with a goal of increasing returns and/or reducing costs. Price risk can be managed, not eliminated.

A futures option is a contract you can buy and sell for a premium that gives you the right but not the obligation to take a position in the futures market. Once you have paid the premium, there are no further risks unless you choose to exercise the option and assume the underlying futures position (the risk can be limited by offsetting the position). For live cattle, the futures option is for a live cattle futures contract (underlying futures) that represents 40,000 pounds of live cattle. A good starting point is to become familiar with the following futures options trading terms.

Hedge

  • is taking a futures position that is equal and opposite a position in the cash market. The purpose is to manage the risk of an unfavourable price move in the future. Buying an option is a method of hedging Put Option- gives the option buyer the right to sell the underlying futures contract at the chosen strike price on or before the expiration date

Call Option

  • gives the option buyer the right to purchase the underlying futures contract at the chosen strike price on or before the expiration date

Option Buyer

  • The purchaser of either a call option or a put option pays the premium and receives the right, but not the obligation, to enter a futures market position

Option Seller

  • The seller of a call or put option receives the premium and is subject to a potential market obligation if the option buyer chooses to exercise the option rights

Premium

  • is the value of an option contract determined by trading between buyers and sellers through a commodity exchange

Underlying Futures Contract

  • This is the specific futures contract that may be bought or sold if the option is exercised

Expiration Date

  • This is the last date on which the option may be exercised and is specified by the commodity exchange.

Strike Price

  • These are set out by the commodity exchange. The option buyer chooses the appropriate strike price for their marketing situation. The strike price is the price at which the holder of an option may choose to exercise their right to sell or buy the underlying futures contract

Through the bidding process between buyers and sellers on the commodity futures exchange (i.e. Chicago Mercantile Exchange (CME); the value (premium) of the option is determined. There are different premium values for puts and calls, for each contract month and for each strike price. The premium is made up of two components, time and intrinsic value. The intrinsic value is the amount realized if the option is exercised immediately (i.e. the difference between the strike price and the current underlying futures contract market price). The time value is the amount the option's premium exceeds the option's intrinsic value. The further an option is from expiration, the higher the time value (more time available for price moves to occur).

There are three ways to manage your original option position, offset it, exercise it, or let it expire. To offset your position means to take an option position equal and opposite to the initial position (i.e. if you purchased a put option you would simply sell the put option and realize the difference between the premium values). Only the option buyer can exercise an option position. When the option is exercised, the buyer and seller are both assigned a futures position (i.e. the buyer of a put option assumes the short futures position and the seller of a put option assumes the long futures position). The option buyer would only exercise the option when it is, "in the money". If an option is "out of the money", the option buyer does nothing and lets the option expire worthless. After the option's expiration date, the option rights are no longer valid.

Besides giving the right to sell the underlying futures contract, purchasing a put option sets a minimum selling price for the commodity. For example, if a live cattle put option was purchased at a strike price of $127 per hundred weight (cwt.) for a premium of $2.275/cwt, the minimum price would be $124.725/cwt (strike price minus premium and commission cost). As the underlying live cattle futures contract value moves below the strike price, the put option buyer will have the opportunity to realize a return on the option either by offsetting or exercising it. If the underlying live cattle futures contract value moves above the strike price, the put option would expire worthless. The option buyer would realize the cash value of the cattle in the spot market and the cost of the premium and commission for the downside protection. Since a put option provides the right to purchase the underlying futures contract, it provides a hedge against lower prices without having to purchase the futures contract and deal with margin calls.

Along with the benefit of hedging prices, put options extend the marketing window, eliminate margin requirements, do not require delivery to liquidate a position, and give the potential to gain from favourable price moves. Consideration must be given to the relevance of the premium cost compared to the protection gained and the comfort level and knowledge of the individual in using futures options.

In summary, hedging with a futures put option is one of the marketing tools that can used to forward price a commodity to protect against a movement in the price. Besides providing protection against falling prices, you can also benefit from rising prices. It is a way to extend the marketing window and work on minimizing price risk with a marketing tool that is relatively easy to enter and exit. This article provided a basic overview of a put option. A CME resource with more detailed information, "Self-Study Guide to Hedging with Livestock Futures and Options" is available at www.cmegroup.com/agriculture.

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