This guide details the placing of an output (short) hedge in the options market for use in reducing the price risk associated with selling an output produced in your business. A short hedge in the options market is referred to as the purchasing of a put option. For example, a cattle producer knows he/she will be selling a pen of cattle two months from now. The producer knows that by selling live cattle for over $62/cwt. he/she can insure a satisfactory profit. Currently, the local live cattle price is $64/cwt., and the producer believes that the fed price may drop during the next few months. By knowing the cost of production of these animals, the producer knows that the $64/cwt. will allow for a satisfactory profit. What can the producer do? The producer cannot sell the cattle now because the cattle are too small; however, the producer could enter the options market and partially off-set any loss in value (decrease in price) with a gain in option 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 your 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 open out-cry is used in matching market supply and demand forces. If you want to place a long hedge using options (put option), there will always be someone willing to write a put 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 guide in this series. As a hedger 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 put option is said to be in the money if the strike price is above the underlying futures price. A put option is said to be at the money if the strike price is equal to the underlying futures price. A put option is said to out of the money if the strike price is below 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 (the difference between the strike price and the underlying futures price) and time value (number of days remaining until expiration of the contract). If the futures market decreases a put option should theoretically increase in value; however, this need not be the case.

What Can Happen With the Short Hedge?

A. Cash Price and Options Value both Decrease

Table 1 outlines the example of a short hedge using a put option in which the cash price and futures price decrease. A decrease in futures price is assumed to be positively related to a change in the put option value. Thus, the option value decreases. Suppose today Calvin Corn Grower knows that he will be selling corn a few months from now. Additionally, Calvin knows that given the current cash price of $2.35/bu. he has the potential to profit. However, he is concerned that the price may decrease prior to selling. Calvin decides to purchase a $2.50/bu. in the money put option for $0.20/bu. Later when the Calvin is ready to sell the corn, 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 put option is now further in the money. Therefore, Calvin sells the corn for $2.15/bu. and sells his put option for $0.35/bu., a $0.15/bu. gain in value. In this case Calvin has improved his selling price of the grain from $2.15/bu. to $2.29/bu. ($2.15/bu. less $0.01/bu. commission plus $0.15/bushel gain in option value).

Table 2 outlines the example of a short hedge using a put option in which the cash price and futures price increase. An increase in futures price is assumed to be inversely related to a change in the put option value. Thus, the option value decreases. Suppose today Calvin Corn Grower knows that he will be selling corn a few months from now. Additionally, Calvin knows that given the current cash price of $2.35/bu. he has the potential to profit. However, he is concerned that the price may decrease prior to selling. Calvin decides to purchase a $2.50/bu. in the money put option for $0.20/bu. Later when the Calvin is ready to sell the corn, 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 put option is now out of the money. Therefore, Calvin sells the corn for $2.60/bu. and sells his put option for $0.05/bu., a $0.15/bu. loss in value. In this case Calvin has decreased his selling price of the grain from $2.60/bu. to $2.44/bu. ($2.60/bu. less $0.01/bu. commission less $0.15/bushel loss in option value). However, Calvin had the potential for unlimited gains (scenario A) with limited losses.

Table 3 outlines the example of a short hedge using a put option in which the cash price and futures price change minimally over the life of the contract. Suppose today Calvin Corn Grower knows that he will be selling corn a few months from now. Additionally, Calvin knows that given the current cash price of $2.35/bu. he has the potential to profit. However, he is concerned that the price may decrease prior to purchasing the hogs. Calvin decides to purchase a $2.50/bu. in the money put option for $0.20/bu. Later when the Calvin is ready to sell corn, the cash and futures prices have changed minimally (no change in basis) and the contract month expiration date is tomorrow. Therefore, Calvin purchases the corn for $2.34/bu. and allows his put option to expire worthless (and Calvin doesn't pay commission costs for allowing the option to expire). In this case Calvin has decreased the price received from $2.34/bu. to $2.135/bu. ($2.34/bu. less $0.005/bu. commission less $0.20/bushel loss in option value). However, Calvin 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 decreases substantially and the option premium only realizes a modest increase in value. In this case, Calvin might want to exercise the put option. That is, Calvin would use his right to sell a futures contract at a later date at $2.50/bu. and buy back in the futures market at the current price of $2.00/bu. Therefore, Calvin would receive $2.19/bu. instead of the current cash price of $1.95/bu. Furthermore, if Calvin would have sold his put option, he would have received $2.09/bu. because the put option only increased in value by $0.15/bushel.

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