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Strategy 1

Conventional Spring Period Hedging by Buying a Put Option

Implemented (hypothetically) on March 15, 2005

West Texas Example:
This information is displayed as an example for educational purposes only.

NYBOT No. 2 Futures Contract : Dec. 05
Futures Price (03/15/05 settlement; cents/lb) 58.000
Strike Price for Purchased Put Options (cents/lb) 57.000
Premium for Purchased Put Options (cents/lb) 4.450
Strike Price for Sold Put Options (cents/lb)  
Premium for Sold Put Options (cents/lb)  
Strike Price for Purchased Call Options (cents/lb)  
Premium for Purchased Call Options (cents/lb)  
Strike Price for Sold Call Options (cents/lb)  
Premium for Sold Call Options (cents/lb)  
Assumed Commissions (cents/lb) 0.0004
Assumed Local Basis (cents/lb) 7.000
Assumed** Harvest-Period Differential Between Futures & Adj. World Price (cents/lb) 8.000

 

Futures: Local Cash Price (1) Net Paid Premiums (2) >Put Option Mkt. Value (3) Call Option Example LDP (4) Total Net Price
44 37.00 4.450 13.00 n.a. 16.00 61.55
45 38.00 4.450 12.00 n.a. 15.00 60.55
46 39.00 4.450 11.00 n.a. 14.00 59.55
47 40.00 4.450 10.00 n.a. 13.00 58.55
48 41.00 4.450 9.00 n.a. 12.00 57.55
49 42.00 4.450 8.00 n.a. 11.00 56.55
50 43.00 4.450 7.00 n.a. 10.00 55.55
51 44.00 4.450 6.00 n.a. 9.00 54.55
52 45.00 4.450 5.00 n.a. 8.00 53.55
53 46.00 4.450 4.00 n.a. 7.00 52.55
54 47.00 4.450 3.00 n.a. 6.00 51.55
55 48.00 4.450 2.00 n.a. 5.00 50.55
56 49.00 4.450 1.00 n.a. 4.00 49.55
57 50.00 4.450 0.00 n.a. 3.00 48.55
58 51.00 4.450 0.00 n.a. 2.00 48.55
59 52.00 4.450 0.00 n.a. 1.00 48.55
60 53.00 4.450 0.00 n.a. 0.00 48.55
61 54.00 4.450 0.00 n.a. 0.00 49.55
62 55.00 4.450 0.00 n.a. 0.00 50.55
63 56.00 4.450 0.00 n.a. 0.00 51.55
64 57.00 4.450 0.00 n.a. 0.00 52.55
65 58.00 4.450 0.00 n.a. 0.00 53.55
66 59.00 4.450 0.00 n.a. 0.00 54.55
67 60.00 4.450 0.00 n.a. 0.00 55.55
68 61.00 4.450 0.00 n.a. 0.00 56.55
69 62.00 4.450 0.00 n.a. 0.00 57.55

Discussion

The conventional put option hedging strategy is the most basic form of hedging against low prices.

It illustrates the advantage of options in setting a price floor (at put strike price less the premium, less the basis) while allowing for you to take advantage of higher cash prices.

The put option fits the analogy of insurance against lower prices.

The LDP works on top of the put option in providing increasing (offsetting) income as prices fall below the low 50s. The "Total Net Price" in this simplified example assumes that growers would offset/exercise their put options at low futures prices, as well as maximize their LDP.

Strategies 2-5 show exmaples of how to reduce the cost of locking in floor price at a more affordable cost.

Notes:

  1. Local price is assumed to differ from futures by a constant basis. In reality, this differential is subject to possible "Basis risk" variations.
  2. Premiums paid (less received) for bought (or sold) options.
  3. These values are net of commissions. These values assume only intrinsic value for purchased options, which is realistic when the option is close to expiration, or when exercising into a futures position.
  4. For illustrative purposes only, future LDP value is represented as a fixed 14-cents below the A-Index, which is assumed to be a fixed 7-cents above futures.In reality, the A-index can vary widely in relation to futures,and also vary to a lesser amount from the AWP.
 
The Cotton Marketing Planner
http://agecon2.tamu.edu/people/faculty/robinson-john/

Dr. John R. C. Robinson
Associate Professor
Extension Economist-Cotton Marketing
Department of Agricultural Economics
Texas A&M University
2124 TAMU
College Station, TX 77843-2124
Phone: (979) 845-8011
Fax: (979) 845-4906
Email: jrcr@tamu.edu