Wheat
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Hedging with wheat futures and options
Why Futures and Options Work Futures Price
Convergence
Time Cash Price
Delivery
How Futures and Options Work Futures as a temporary substitute for cash --producers/suppliers can sell futures before actual cash sale to establish price --end users can buy futures before actual cash purchase to establish price ❂ Options as price insurance -- premium can be paid to insure against an adverse price move ❂
Futures and Options Comparison ADVANTAGES Hedging in Futures 1.Reduces price risk 2.Offers marketing flexibility
Buying Options 1.Reduces price risk 2.Offers marketing flexibility 3.Known cost; risk limited to premium 4.Maintains profit potential 5.No margin account needed; no margin calls 6.No further action required, but may be offset or exercised if advantageous
Writing options 1.Generates income from premium received 2.Offers marketing flexibility
Futures and Options Comparison DISADVANTAGES Hedging in Futures 1.Margin account needed; subject to margin calls 2.Must perform on contract or offset 3.Profit potential limited as is loss potential
Buying Options 1.Must pay premium up front 2.Premium may be lost if option expires worthless
Writing options 1.Margin account needed; subject to margin calls 2.May be required to perform if option is exercised 3.Risk unlimited if price moves adversely 4.Profit limited to premium; no potential for further gains from option position
The Short Hedge In A Declining Market Futures Transaction
Cash Transaction
April 15 Sell futures
$3.48
-
July 15 Sell cash wheat Buy back futures
$3.29
$3.29 -
Futures profit/ Cash received
+.19
3.29
Total Return
.19
+
3.29 = $3.48
The Short Hedge In An Advancing Market Futures Transaction
Cash Transaction
April 15 Sell futures
$3.48
-
July 15 Sell cash wheat Buy back futures
$3.60
$3.60 -
Futures loss/ Cash received
-.12
3.60
Total Return
-.12
+
3.60 = $3.48
Producer Hedging At Various Price Levels
Futures Price $4.00 $3.75 $3.48 $3.25 $3.00
Profit/Loss from Futures Position -.52 -.27 .00 +.23 +.48
Proceeds from Cash Sale +4.00 +3.75 +3.48 +3.25 +3.00
= = = = =
Net Price Received
Net without Futures Hedge
3.48 3.48 3.48 3.48 3.48
4.00 3.75 3.48 3.25 3.00
As the table indicates, the net price received is a constant $3.48. The short hedge protects a selling price against a declining market, but precludes gains if the market advances. With the short hedge, additional returns are relinquished to protect an acceptable selling price. * Note: These examples do not account for basis or commission fees. Hedge results will be affected by changes in the basis, or the difference between the futures price and the cash price at a specific location.
The Long Hedge In An Advancing Market Cash Transaction
Futures Transaction
January 22 Buy futures
-
$3.60
April 15 Buy cash wheat (futures price less .20 basis)
$3.65
-
Sell Futures
-
3.85
Futures profit/ Cash paid
$3.65
+.25
Net Price paid
$3.65
-.25 = $3.40
The Long Hedge In A Declining Market Futures Transaction
January 22 Buy futures
-
$3.60
April 15 Buy cash wheat (futures price less .20 basis)
$3.18
-
Sell Futures Futures loss/ Cash paid
$3.18
3.38 -.22
Net Price paid
$3.18
+.22 = $3.40
❂
Cash Transaction
Elevator Hedging At Various Price Levels
Futures Price $4.10 $3.90 $3.60 $3.40 $3.25
Cash Price Paid - Profit/Loss from (Futures-Basis) - Futures Hedge 3.90 3.70 3.40 3.20 3.05
(+.50) (+.30) (+.00) (-.20) (-.35)
Net Price Paid = = = = =
3.40 3.40 3.40 3.40 3.40
Net without Futures Hedge 3.90 3.70 3.40 3.20 3.05
As the table indicates, the net price paid is a constant $3.40. The long hedge protects a buying price against an advancing market, but precludes a lower price if the market declines. With the long hedge, additional gains from lower prices are relinquished to protect an acceptable buying price. * Note: These examples do not account for commission fees and assume a constant basis of 20 cents under the futures price. Hedge results will be affected by changes in the basis.
❂
The Producer: Options Example 1 Futures $3.50 $3.40 $3.30 $3.20 $3.10 $3.00 $2.90
Premium Cost(bu.) -.10 -.10 -.10 -.10 -.10 -.10 -.10
+ + + + + + + +
Option's Intrinsic Value (Strike-Futures) = .00 = .00 = .00 = .10 = .20 = .30 = .40 =
Net Price Received $3.40 $3.30 $3.20 $3.20 $3.20 $3.20 $3.20
Net Price w/o Option $3.50 $3.40 $3.30 $3.20 $3.10 $3.00 $2.90
*Note that the minimum price received with options is equal to the strike price selected less the premium paid ($3.30-.10=$3.20). The producer who bought the put has locked in a minimum price of $3.20, but has not eliminated his potential to gain if prices increase. The producer who does not buy the put saves the premium cost if prices increase, but has no downside protection. (This example does not account for basis or commission fees.)
The Producer: Options Example 2 Option's Futures Price $3.80 $3.70 $3.60 $3.50 $3.40 $3.30 $3.20 $3.10
Forward Contract Premium Intrinsic Value Price Received -Cost(bu.) +(Futures-Strike) = $3.30 - .06 + .40 = $3.30 - .06 + .30= $3.30 - .06 + .20 = $3.30 - .06 + .10 = $3.30 - .06 + .00 = $3.30 - .06 + .00 = $3.30 - .06 + .00 = $3.30 - .06 + .00 =
Net Price Net Price Received w/o Option $3.64 $3.30 $3.54 $3.30 $3.44 $3.30 $3.34 $3.30 $3.24 $3.30 $3.24 $3.30 $3.24 $3.30 $3.24 $3.30
*Note the minimum price with options is equal to the forward contract price less the premium paid ($3.30-.06=$3.24). The producer who bought the call has locked in a minimum price of $3.24, but has not eliminated his potential to gain if prices increase. The producer who does not buy the call saves the premium cost, but has eliminated his potential to gain if prices increase. (This example does not account for basis or commission fees.)
The Country Elevator: Options Example
Futures Price $3.60 $3.50 $3.40 $3.20 $3.10 $2.90
Option's Premium Intrinsic Value Net Price +Cost(bu.) -(Futures-Strike) =Paid +.20 -.40 =$3.40 +.20 -.30 =$3.40 +.20 -.20 =$3.40 +.20 -.00 =$3.40 +.20 -.00 =$3.30 +.20 -.00 =$3.10
Net Price w/o Option $3.60 $3.50 $3.40 $3.20 $3.10 $2.90
*Note that the maximum price with options is equal to the strike price selected plus the premium paid ($3.20+.20=$3.40). The merchandiser who bought the call has locked in a maximum buying price of $3.40, but has not eliminated his potential to benefit from price declines. The merchandiser who does not buy the call saves the premium cost if prices decline, but has no upside protection. (This example does not account for basis or commission fees.)
The Baker: Options Example Futures Price $3.60 $3.50 $3.40 $3.30 $3.20 $3.10 $3.00
Option's Premium Intrinsic Value -Cost(bu.) +(Strike-Futures) -.10 +.00 -.10 +.00 -.10 +.00 -.10 +.10 -.10 +.10 -.10 +.10 -.10 +.10
Net Inventory =Value =$3.50 =$3.40 =$3.30 =$3.30 =$3.30 =$3.30 =$3.30
Net Value w/o Option $3.60 $3.50 $3.40 $3.30 $3.20 $3.10 $3.00
*Note that the minimum value with options is equal to the strike price selected less the premium paid ($3.40-.10=$3.30). The baker who bought the put has locked in a minimum inventory value of $3.30, but has not eliminated his potential for profit if prices move up. The baker who does not buy the put saves the premium cost if prices increase, but has no downside protection. (This example does not account for basis or commission fees.)
The Miller: Options Example Futures Price
Option's Premium Intrinsic Value Net Price Net Price +Cost(bu.) -(Futures-Strike) +Basis = Paid w/o Option
$3.70 $3.60 $3.50 $3.40 $3.30 $3.20 $3.10 $3.00 $2.90
+.19 +.19 +.19 +.19 +.19 +.19 +.19 +.19 +.19
-.50 -.40 -.30 -.20 -.10 -.00 -.00 -.00 -.00
+.30 +.30 +.30 +.30 +.30 +.30 +.30 +.30 +.30
= = = = = = = = =
$3.69 $3.69 $3.69 $3.69 $3.69 $3.69 $3.59 $3.49 $3.39
$4.00 $3.90 $3.80 $3.70 $3.60 $3.50 $3.40 $3.30 $3.20
*Note that the maximum price paid with options is equal to the strike price selected plus the premium paid, plus the basis ($3.20+.19+.30=$3.69). The miller who bought the call has locked in a maximum buying price of $3.69, but has not eliminated his potential to gain if prices decline. The miller who does not buy the call saves the premium cost if prices decline, but has no upside protection. (This example does not account for commission fees.)
Individual Considerations Basis correlation with futures market ❂ Size of operation ❂ Production risks ❂ Storage availability ❂ Personal risk tolerance level ❂
Stress-Testing “What if?” scenarios ❂ “Worst case” scenarios ❂ Range of possible outcomes ❂
Kansas City Board of Trade
Why Futures and Options Work Futures Price
Convergence
Time Cash Price
Delivery
How Futures and Options Work Futures as a temporary substitute for cash --producers/suppliers can sell futures before actual cash sale to establish price --end users can buy futures before actual cash purchase to establish price ❂ Options as price insurance -- premium can be paid to insure against an adverse price move ❂
Futures and Options Comparison ADVANTAGES Hedging in Futures 1.Reduces price risk 2.Offers marketing flexibility
Buying Options 1.Reduces price risk 2.Offers marketing flexibility 3.Known cost; risk limited to premium 4.Maintains profit potential 5.No margin account needed; no margin calls 6.No further action required, but may be offset or exercised if advantageous
Writing options 1.Generates income from premium received 2.Offers marketing flexibility
Futures and Options Comparison DISADVANTAGES Hedging in Futures 1.Margin account needed; subject to margin calls 2.Must perform on contract or offset 3.Profit potential limited as is loss potential
Buying Options 1.Must pay premium up front 2.Premium may be lost if option expires worthless
Writing options 1.Margin account needed; subject to margin calls 2.May be required to perform if option is exercised 3.Risk unlimited if price moves adversely 4.Profit limited to premium; no potential for further gains from option position
The Short Hedge In A Declining Market Futures Transaction
Cash Transaction
April 15 Sell futures
$3.48
-
July 15 Sell cash wheat Buy back futures
$3.29
$3.29 -
Futures profit/ Cash received
+.19
3.29
Total Return
.19
+
3.29 = $3.48
The Short Hedge In An Advancing Market Futures Transaction
Cash Transaction
April 15 Sell futures
$3.48
-
July 15 Sell cash wheat Buy back futures
$3.60
$3.60 -
Futures loss/ Cash received
-.12
3.60
Total Return
-.12
+
3.60 = $3.48
Producer Hedging At Various Price Levels
Futures Price $4.00 $3.75 $3.48 $3.25 $3.00
Profit/Loss from Futures Position -.52 -.27 .00 +.23 +.48
Proceeds from Cash Sale +4.00 +3.75 +3.48 +3.25 +3.00
= = = = =
Net Price Received
Net without Futures Hedge
3.48 3.48 3.48 3.48 3.48
4.00 3.75 3.48 3.25 3.00
As the table indicates, the net price received is a constant $3.48. The short hedge protects a selling price against a declining market, but precludes gains if the market advances. With the short hedge, additional returns are relinquished to protect an acceptable selling price. * Note: These examples do not account for basis or commission fees. Hedge results will be affected by changes in the basis, or the difference between the futures price and the cash price at a specific location.
The Long Hedge In An Advancing Market Cash Transaction
Futures Transaction
January 22 Buy futures
-
$3.60
April 15 Buy cash wheat (futures price less .20 basis)
$3.65
-
Sell Futures
-
3.85
Futures profit/ Cash paid
$3.65
+.25
Net Price paid
$3.65
-.25 = $3.40
The Long Hedge In A Declining Market Futures Transaction
January 22 Buy futures
-
$3.60
April 15 Buy cash wheat (futures price less .20 basis)
$3.18
-
Sell Futures Futures loss/ Cash paid
$3.18
3.38 -.22
Net Price paid
$3.18
+.22 = $3.40
❂
Cash Transaction
Elevator Hedging At Various Price Levels
Futures Price $4.10 $3.90 $3.60 $3.40 $3.25
Cash Price Paid - Profit/Loss from (Futures-Basis) - Futures Hedge 3.90 3.70 3.40 3.20 3.05
(+.50) (+.30) (+.00) (-.20) (-.35)
Net Price Paid = = = = =
3.40 3.40 3.40 3.40 3.40
Net without Futures Hedge 3.90 3.70 3.40 3.20 3.05
As the table indicates, the net price paid is a constant $3.40. The long hedge protects a buying price against an advancing market, but precludes a lower price if the market declines. With the long hedge, additional gains from lower prices are relinquished to protect an acceptable buying price. * Note: These examples do not account for commission fees and assume a constant basis of 20 cents under the futures price. Hedge results will be affected by changes in the basis.
❂
The Producer: Options Example 1 Futures $3.50 $3.40 $3.30 $3.20 $3.10 $3.00 $2.90
Premium Cost(bu.) -.10 -.10 -.10 -.10 -.10 -.10 -.10
+ + + + + + + +
Option's Intrinsic Value (Strike-Futures) = .00 = .00 = .00 = .10 = .20 = .30 = .40 =
Net Price Received $3.40 $3.30 $3.20 $3.20 $3.20 $3.20 $3.20
Net Price w/o Option $3.50 $3.40 $3.30 $3.20 $3.10 $3.00 $2.90
*Note that the minimum price received with options is equal to the strike price selected less the premium paid ($3.30-.10=$3.20). The producer who bought the put has locked in a minimum price of $3.20, but has not eliminated his potential to gain if prices increase. The producer who does not buy the put saves the premium cost if prices increase, but has no downside protection. (This example does not account for basis or commission fees.)
The Producer: Options Example 2 Option's Futures Price $3.80 $3.70 $3.60 $3.50 $3.40 $3.30 $3.20 $3.10
Forward Contract Premium Intrinsic Value Price Received -Cost(bu.) +(Futures-Strike) = $3.30 - .06 + .40 = $3.30 - .06 + .30= $3.30 - .06 + .20 = $3.30 - .06 + .10 = $3.30 - .06 + .00 = $3.30 - .06 + .00 = $3.30 - .06 + .00 = $3.30 - .06 + .00 =
Net Price Net Price Received w/o Option $3.64 $3.30 $3.54 $3.30 $3.44 $3.30 $3.34 $3.30 $3.24 $3.30 $3.24 $3.30 $3.24 $3.30 $3.24 $3.30
*Note the minimum price with options is equal to the forward contract price less the premium paid ($3.30-.06=$3.24). The producer who bought the call has locked in a minimum price of $3.24, but has not eliminated his potential to gain if prices increase. The producer who does not buy the call saves the premium cost, but has eliminated his potential to gain if prices increase. (This example does not account for basis or commission fees.)
The Country Elevator: Options Example
Futures Price $3.60 $3.50 $3.40 $3.20 $3.10 $2.90
Option's Premium Intrinsic Value Net Price +Cost(bu.) -(Futures-Strike) =Paid +.20 -.40 =$3.40 +.20 -.30 =$3.40 +.20 -.20 =$3.40 +.20 -.00 =$3.40 +.20 -.00 =$3.30 +.20 -.00 =$3.10
Net Price w/o Option $3.60 $3.50 $3.40 $3.20 $3.10 $2.90
*Note that the maximum price with options is equal to the strike price selected plus the premium paid ($3.20+.20=$3.40). The merchandiser who bought the call has locked in a maximum buying price of $3.40, but has not eliminated his potential to benefit from price declines. The merchandiser who does not buy the call saves the premium cost if prices decline, but has no upside protection. (This example does not account for basis or commission fees.)
The Baker: Options Example Futures Price $3.60 $3.50 $3.40 $3.30 $3.20 $3.10 $3.00
Option's Premium Intrinsic Value -Cost(bu.) +(Strike-Futures) -.10 +.00 -.10 +.00 -.10 +.00 -.10 +.10 -.10 +.10 -.10 +.10 -.10 +.10
Net Inventory =Value =$3.50 =$3.40 =$3.30 =$3.30 =$3.30 =$3.30 =$3.30
Net Value w/o Option $3.60 $3.50 $3.40 $3.30 $3.20 $3.10 $3.00
*Note that the minimum value with options is equal to the strike price selected less the premium paid ($3.40-.10=$3.30). The baker who bought the put has locked in a minimum inventory value of $3.30, but has not eliminated his potential for profit if prices move up. The baker who does not buy the put saves the premium cost if prices increase, but has no downside protection. (This example does not account for basis or commission fees.)
The Miller: Options Example Futures Price
Option's Premium Intrinsic Value Net Price Net Price +Cost(bu.) -(Futures-Strike) +Basis = Paid w/o Option
$3.70 $3.60 $3.50 $3.40 $3.30 $3.20 $3.10 $3.00 $2.90
+.19 +.19 +.19 +.19 +.19 +.19 +.19 +.19 +.19
-.50 -.40 -.30 -.20 -.10 -.00 -.00 -.00 -.00
+.30 +.30 +.30 +.30 +.30 +.30 +.30 +.30 +.30
= = = = = = = = =
$3.69 $3.69 $3.69 $3.69 $3.69 $3.69 $3.59 $3.49 $3.39
$4.00 $3.90 $3.80 $3.70 $3.60 $3.50 $3.40 $3.30 $3.20
*Note that the maximum price paid with options is equal to the strike price selected plus the premium paid, plus the basis ($3.20+.19+.30=$3.69). The miller who bought the call has locked in a maximum buying price of $3.69, but has not eliminated his potential to gain if prices decline. The miller who does not buy the call saves the premium cost if prices decline, but has no upside protection. (This example does not account for commission fees.)
Individual Considerations Basis correlation with futures market ❂ Size of operation ❂ Production risks ❂ Storage availability ❂ Personal risk tolerance level ❂
Stress-Testing “What if?” scenarios ❂ “Worst case” scenarios ❂ Range of possible outcomes ❂
Kansas City Board of Trade
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