This guide details the placing of an input (long) hedge in the options market for use in reducing the price risk associated with buying an input used in your business. A long hedge in the options market is accomplished by purchasing a call option. For example, a swine producer knows he/she will be buying a pen of feeder-pigs two months from now. To feed the pen of weaner pigs, the producer will need 5,000 bushels of corn (one full contract at the Chicago Board of Trade) during the next four months to use in the production of feed. Corn is an input into the production of swine. Currently, the local cash corn price is at $2.35/bushel, and the producer believes that the corn price may rise during the next few months. By knowing the cost of production for the hogs, the producer knows that the $2.35/bushel will allow for profit potential. What can the producer do? The producer can purchase the grain now; however, he/she will have to pay storage on the grain for the next few months, increasing the price above $2.40/bushel. Alternatively, the producer could enter the options market and partially off-set any loss in value (increase in price) with a gain in the options value.

How do I Place a Hedge?

Placing a hedge can be a simple process. First, knowing your cost of production helps you know when to place a hedge. To place a hedge, you need to contact a broker with whom you place an order. Most large communities have a broker who will take your order for a set fee (as is common when placing any futures/options market order). The broker can be helpful in informing you on how to appropriately place and exit your hedging position. The broker has a stake, i.e., commission, in making sure your experience with hedging is a good one. After you have placed the order with the broker, the broker will contact a brokerage house at the commodity exchange and relay the order. On the trading floor of the trading commission open out-cry is used in matching market supply and demand forces. If you want to place a long hedge using options (call option), there will always be someone willing to write a call option provided you are willing to pay the market price. This process is known as arbitrage and is discussed in more detail in accompanying risk management guides in this series. You must also know at what strike price you would like to enter the options market. For more information see an Introduction to Hedging Agricultural Commodities with Options.

In the, Out of the, and At the Money Options, What is the Difference?

The price paid for the option is referred to as the premium. The amount of the premium paid is related to the strike price. The strike price chosen comes from a predetermined range of values that is different for each commodity. A call option is said to be in the money if the strike price is below the underlying futures price. A call option is said to be at the money if the strike price is equal to the underlying futures price. A call option is said to out of the money if the strike price is above the underlying futures price. At any given time, the range of strike prices quoted will cover values in the money, at the money, and out of the money. Thus, a hedger or speculator has the option of purchasing an option at any of these three levels. Typically, options in the money will have the highest premium, followed by options at the money, and options out of the money will be the cheapest.

What Determines the Value of an Option Premium?

The option premium is the value the hedger pays for the right to later take a futures position. The premium is based on the intrinsic value (arbitragers perceptions) and time value (time remaining until expiration of the contract). Thus, changes in the value of the option are due to changes in the futures market price (intrinsic value) and days until expiration (time value). If the futures market increases a call option should theoretically increase in value; however, this need not be the case.

What Can Happen With the Long Hedge?

Any of three scenarios can arise between the cash and option value. Even though a loss may be shown from taking a position in the options market, the final price must be compared to purchasing the grain in advance and paying storage costs. Basis is held constant for the examples below.

A. Cash Price and Options Value both Increase

Table 1 outlines the example of a long hedge using a call option in which the cash price and futures price increase. An increase in futures price is assumed to be positively related to a change in the option value. Thus, the option value increases. Suppose today Heidi Hog Farmer knows that she will be purchasing a pen of weaner pigs a few months from now. Additionally, Heidi knows that given the current cash price of $2.35/bu. she has the potential to feed-out these pigs for a profit. However, she is concerned that the price may increase prior to purchasing the hogs. Heidi decides to purchase a $2.50/bu. out of the money call option for $0.20/bu. Later when Heidi is ready to purchase the hogs and purchase corn to make feed, the cash and futures prices have increased to $2.60/bu. and $2.65/bu., respectively (no change in basis). The futures price has increased such that the call option is now in the money. Therefore, Heidi purchases the corn for $2.60/bu. and sells her call option for $0.35/bu., a $0.15/bu. gain in value. By purchasing a call option, Heidi has decreased her cost of purchasing the grain from $2.60/bu. to $2.46/bu. ($2.60/bu. plus $0.01/bu. commission less $0.15/bushel gain in option value).

Table 2 outlines the example of a long hedge using a call option in which the cash price and futures price decrease. A decrease in futures price is assumed to be inversely related to a change in the option value. Thus, the option value decreases. Suppose today Heidi Hog Farmer knows that she will be purchasing a pen of weaner pigs a few months from now. Additionally, Heidi knows that given the current cash price of $2.35/bu. she has the potential to feed-out these pigs for a profit. However, she is concerned that the price may increase prior to purchasing the hogs. Heidi decides to purchase a $2.50/bu. out of the money call option for $0.20/bu. Later when Heidi is ready to purchase the hogs and purchase corn to make feed, the cash and futures prices have decreased to $2.15/bu. and $2.20/bu., respectively (no change in basis). The futures price has decreased such that the call option is now even more out of the money. Therefore, Heidi purchases the corn for $2.15/bu. and sells her call option for $0.02/bu., a $0.18/bu. loss in value. In this case Heidi has increased the cost of purchasing the grain from $2.15/bu. to $2.34/bu. ($2.15/bu. plus $0.01/bu. commission plus $0.18/bushel loss in option value). However, Heidi had the potential for unlimited gains (scenario A) with limited losses.

Table 3 outlines the example of a long hedge using a call option in which the cash price and futures price changes minimally over the life of the contract. Suppose today Heidi Hog Farmer knows that she will be purchasing a pen of weaner pigs a few months from now. Additionally, Heidi knows that given the current cash price of $2.35/bu. she has the potential to feed-out these pigs for a profit. However, she is concerned that the price may increase prior to purchasing the hogs. Heidi decides to purchase a $2.50/bu. out of the money call option for $0.20/bu. Later when Heidi is ready to purchase the hogs and purchase corn to make feed, the cash and futures prices have changed minimally (no change in basis) and the contract month expiration date is tomorrow. Therefore, Heidi purchases the corn for $2.34/bu. and allows her call option to expire worthless (and Heidi doesn't pay commission costs for allowing the option to expire). In this case Heidi has increased the cost of purchasing the grain from $2.34/bu. to $2.545/bu. ($2.34/bu. plus $0.005/bu. commission plus $0.20/bushel loss in option value). However, Heidi had the potential for unlimited gains (scenario A) with limited losses.

Table 4 outlines an example similar to scenario A above; however, in this case the futures price increases substantially and the option premium only realizes a modest increase. In this case, Heidi might want to exercise the call option. That is, Heidi would use her right to buy a futures contract at a later date at $2.50/bu. and sell back in the futures market at the current price of $2.90/bu. Therefore, Heidi would pay only $2.41/bu. instead of the current cash price of $2.85/bu. Furthermore, if Heidi would have sold her call option, she would have paid $2.51/bu. because the call option only increased in value by $0.35/bushel.

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