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Marketing Sample LessonMK120 Why Buy or Sell Options? MAIN IDEA: Who buys or sells options and why? Options traders at the Chicago Board of Trade buy and sell a million to a million and a half puts and calls every month. Each of these transactions involves one buyer and one seller. In each case, the buyer and the seller have a reason for making the trade. They have an objective they want to accomplish. TWO TYPES OF TRADERS With that many trades taking place, you would think there would be many different reasons for buying or selling options contracts. Actually there are not. The people who buy and sell options can be grouped into two types of traders: Hedgers: Hedgers use options to protect against price moves that would otherwise reduce the cash market price they will receive for a commodity; or the buying price they will pay when purchasing a commodity. Speculators: Speculators buy and sell options to earn a profit. They can do this if they are able to correctly predict price moves.
This lesson focuses on hedgers rather than speculators. There are a number of different situations in which producers, handlers and processors of ag commodities can use options hedges to reduce risk and improve net returns. WHO HEDGES OPTIONS? Farmers with crops or livestock to sell: For hedging purposes, a farmer who expects OUTPUT prices to fall will buy a PUT option at a STRIKE PRICE above the cost of production. Output prices are the prices on the commodities a farmer produces and has to sell. Example: In November, a cattle feeder buys PUT options on April cattle with a strike price of $68 for a premium of $2.50. If in April cattle prices fall to $60, he exercises, or offsets, the put. This yields a net price of $68 - $2.50 = $65.50. If prices go to $70, the option should be allowed to expire, yielding a net price of $70 - $2.50 = $67.50. Note: these calculations are a shorthand method for estimating the hedging results. You will find more details on how hedges work in AgEdNet.com lessons MK121 Calculating Options Hedging Results and MK122 Pricing with Options Vs. Futures. Terminal grain elevators, local elevators and co-ops: Elevators with grain in inventory can use options in the same way that it is used by producers who will eventually sell in the cash market. Elevator operators can buy put options to ensure a minimum floor selling price for their inventory. If prices fall, they can exercise their put option and gain a favorable position in the futures market that will offset the loss of selling price for the grain they are holding. Likewise, an elevator operator can use the offset strategy, selling the puts purchased earlier for a higher premium. The gain in premium is then added to the selling price for grain sold from inventory. If prices rise, elevator operators holding puts can simply allow them to expire and earn additional profits through the sale of grain at higher prices. Farmers with crops or livestock to buy: For hedging purposes, a farmer who expects prices for a purchased input, such as feed or feeder livestock, to rise will buy a CALL option at a strike price below the break-even cost level. Example: In December, a hog farmer buys a call option on July corn at a strike price of $2.30 for a premium of 10 cents. If corn prices rise to $2.85 the next spring or early summer, the farmer exercises, or offsets, the call. This yields a net price of $2.30 + $.10 = $2.40. If corn prices go to $2.20, the farmer lets the option expire. This yields a net price of $2.20 + $.10 = $2.30. Note: these calculations are a shorthand method for estimating the hedging results. You will find more details on how hedges work in AgEdNet.com lessons MK121 Calculating Options Hedging Results and MK122 Pricing with Options Vs. Futures. Food processors and exporters: The main concern of processors and exporters is that prices will rise for commodities they will purchase at a future date. Thus they will use options in the same way as farmers who must buy crops or livestock. Buyers of raw materials, such as a meat packer or a soybean processor will purchase call options to hedge against a rise in prices. Likewise, buying call options can reduce the risk to an exporter who has tendered an offer to sell crops overseas, but does not know for days if the offer will be accepted. In both cases, if prices fall the buyer of the call can walk away from the contract, losing only the premium paid for the call. But if prices go up, the buyer has locked in a minimum price. WHO WRITES OPTIONS? The seller, often called the writer, of an option normally is the one that is taking the risk, while the hedger is the buyer of the option to avoid risk. The seller receives a premium to accept that risk. However, there are some limited situations where one could sell an option and add the premium to transactions in the cash market. This is not considered to be hedging because it requires taking the risk that the option will be exercised. The seller is then forced to take a losing position in the futures markets. Elevator operators: Writing options is another strategy used by some grain elevators operators holding large inventories of grain. These operators will write call options, taking in the amount of the premium.
Farmers: Of course, farmers may also sell, or write options. But this strategy has unlimited risk and is NOT strictly a hedging strategy. The maximum amount of gain for the person selling the option is the amount of the premium. Example: If a producer has sold a call and prices decline more than the amount of the premium, the farmer is unhedged against the additional loss. Even worse, the farmer will have actually locked in a maximum price instead of a minimum price. Any improvement in cash prices is offset by a loss in the options market. This is essentially a speculative strategy. It can be very profitable in years when markets remain quiet and there is no reason for the buyer of the option to exercise. In that case the farmer gains the premium which can be added to a selling price, or used to help pay for a purchased input. But if markets become volatile, it also can generate significant losses. Processors and exporters: As with farmers, processors and exporters can also write, or sell puts or calls, in order to profit by the amount of the premium. But the strategy is a speculative one that only works if the option is not exercised by the seller. EXERCISES: 1. Explain what kind of market outlook (bullish or bearish) a cattle producer expects if the producer is buying a PUT option on December cattle. 2. A hog producer buys a call option on December corn at a strike price of $2.40, paying a premium of 7 cents. If prices go to $2.60 by December, what is the net price the producer will pay for corn? Show your calculations. 3. Explain why selling, or writing, a put is NOT a hedging strategy? 4. Follow market comments and review reports you can find on the Internet, your market information network or other sources for a few days. Look for indications of trends in prices. Then explain a logical options strategy for one or more of the commodities you followed. INTERNET RESOURCES:
** Chicago Board of Trade - Market Commentaries
** Kansas City Board of Trade - Market Commentary
** Stewart-Peterson TEST:
1. Name the two broad categories of options users. 2. If a soybean farmer wants to protect against price declines, selling a call makes the most sense. TRUE or FALSE? 3. If an exporter who expects to buy cash grain, writes a call and prices go up, the exporter will have no price protection. TRUE or FALSE?
4. If a cattle producer buys a put for April cattle at a strike price of $67 for a premium of $3, the lowest possible net price is:
5. A co-op holding grain in inventory would sell a call option if prices were expected to:
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TEACHER'S GUIDEMK120 Why Buy or Sell Options?OBJECTIVE: Students will be able to list those who would have a reason to buy or sell on the options markets; and they will also be able to explain the reasons why each would buy or sell an option. PREPARATION: Review the basics of options trading as presented in this and other lessons in this group, MK117 through MK122. Be ready to answer student questions. Help students find market comments required for exercise #4. Review Internet Resource pages. INTERNET RESOURCES:
** Chicago Board of Trade - Market Commentaries
** Kansas City Board of Trade - Market Commentary
** Stewart-Peterson IMPORTANT TERMS: call, hedgers, input prices, output prices, purchased input, put, speculators, strike prices, write. EXTENSION: Find out who in the community is a user or potential user of options. Does the local elevator make use of them? Do local farmers use them as part of their marketing plans? If possible, have someone come in and talk about how they use options as a hedging tool. EXERCISE ANSWERS: 1. Buying a put option is a hedge against declining prices, so the cattle producer most likely is expecting a bearish outlook. However, in some situations, producers make hedging a routine to protect against risk. Their strategy is to watch for and lock in a profitable price without trying to outguess markets. 2. The cost of the corn is the strike price plus the premium paid. Thus the simple calculations are: $2.40 + $.07 = $2.47 3. Writers of options have unlimited risk. The maximum amount of gain from the options strategy is the amount of the premium. If prices decline further than that, the farmer is still unhedged against that loss. 4. If the outlook is bullish, a producer-seller may not want to hedge at all, while a user-buyer could buy a call. If the outlook is bearish, a producer-seller could buy a put, while the user-buyer may wish to remain unhedged. These are the most common and basic strategies. They are call "selective hedging" strategies that require taking a certain amount of risk. It requires depending on market outlook forecasts which may be wrong. A less risky approach is to hedge whenever a profitable price level can be achieved. TEST KEY:
1. Name the two broad categories of options users. 2. If a soybean farmer wants to protect against price declines, selling a call makes the most sense. TRUE or FALSE? FALSE. Selling an option is a risky strategy. Once prices drop by the amount of the premium, the farmer is unhedged. 3. If an exporter who expects to buy cash grain, writes a call and prices go up, the exporter will have no price protection. TRUE or FALSE? FALSE. The exporter will be able to lower purchase prices by the amount of the premium. However, the exporter also is at risk that the call will be exercised, leaving the exporter with a losing short position in futures markets.
4. If a cattle producer buys a put for April cattle at a strike price of $67 for a premium of $3, the lowest possible net price is: Correct answer: A. Strike price less premium equals net price: $67 - $3 = $64
5. A co-op holding grain in inventory would sell a call option if prices were expected to: Correct answer: A. If prices fall, the option will not be exercised and the co-op will keep the premium, adding it to the value of the grain in inventory. CROSSWORD PUZZLE ANSWERS:
Across: 2. Inventory, 4. Processor, 7. Trade, 9. Call, 10. Exporter, 11. Input, 13. CBOT, 14. Writer. END
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