Session 1, Lesson 12 / WRAP UP
As we wrap up the Introduction to Options, I’d like to use this final lesson to pull together a few areas that we haven’t touched on yet, as well as recap some of the high points of previous lessons.
We’ve looked at purchasing put options in previous lessons as a way to hedge downside risk. We’ve also looked at a few strategies involving the purchase of call options. Another strategy involving the purchase of call options which should be considered primarily by anyone who wants to hedge his exposure.
A hog producer with a finishing operation could purchase soybean meal calls, and thereby insure himself a maximum price he would have to pay for his meal. To determine his maximum price, he would take the strike price and add to it the premium cost and transaction costs and make any basis adjustments. This same operator could also hedge his corn inputs in a similar way using corn call options. By using both the corn and the meal call options the farmer could substantially protect a good portion of his feed costs.
This same operator could then use live hog put options to guarantee a minimum selling price for his hogs and thereby have himself hedged or protected all the way around. By using options in this example instead of futures, the operator still leaves himself open to lower production costs if indeed the market stays under the strike price for his corn and soybean meal, and also higher sale prices for his hogs, should they move above the put option strike price for his hog option. With this example, you could begin to see how careful use of options can really help a farm operator manage his risk.
The hog operator isn’t the only one to enjoy the benefits of options. A feedlot operator also has many choices. Call options could be used to protect the price of feeder cattle which need to be put into the lot. Call options can be used to protect the price of the corn which that feedlot needs, and finally the finished product can be protected using put options on live cattle. I’ve seen some fairly sophisticated operations that use options extensively in this manner.
One of the nice things about options is that they are widely available. All the options that we’ve talked about in this course are traded on your major commodity exchanges in Chicago. However, you can’t just pick up the phone and call the exchange and tell them that you’d like to buy an option. All option transactions are handled through a broker. You might choose to use a local broker in your home town or you might prefer to seek out a specialist with expertise in using options as part of a total Investment Trading Program. Our own firm, Phillip GNI Futures, specializes in working with Investors Traders and hedgers..
I believe that we can do an excellent job in working with a Trader to assist him with his marketing, but at the same time there are certainly a number of firms out there with very capable and qualified people to assist you in your trading decisions.
There are pros and cons to each method of selecting someone to work with, but in the final analysis, what’s most important is who are you comfortable and confident in working with? Unless you select a broker or advisor that you have confidence in and are comfortable working with on a day-to-day basis, your trading program is doomed from the onset. It’s an important decision and I would urge you to consider it carefully.
Once you’ve selected someone to do business with, the process is fairly simple. After completing the necessary paperwork to establish an account with the firm you selected, you’re then in a position to place orders and develop your trading program as you see fit. Each company can give you the specifics on how the process goes from that point.
A popular question that customers ask is how big are these contracts? Each option that you purchase is good for one futures contract. Working on that idea, when you purchase one corn option, that option is good for one futures contract at the Chicago Board of Trade, which happens to be 5,000 bushel. A live cattle option would be good for one live cattle futures contract, which is 40,000 pounds. There are even options on mini soybeans. A mini soybean contract is 1,000 bushel for smaller operations. Check with your broker for the specifics before placing any orders.
Another question that is commonly asked is, “As an operator I see the advantages of buying an option, but why would anybody be a seller of options with the unlimited risk that they carry for such a limited return?” As a trader/hedger and as a buyer of options, you have a very fixed and limited risk factor in the amount of premium you pay, but yet have a tremendous amount of profit potential if the market moves in a way favorable for your position.
Just the opposite is true though for the option seller. Why is the option seller willing to take such a big risk? To a large degree, the answer boils down to two factors. One is odds and the other is risk management. Let’s go back to one of our first examples of options being like insurance. How often do insurance companies lose money? While it’s true that on any given policy they may suffer loss, and as of course a business will have policies that lose them money, overall they are successful and profitable because they know the odds. An insurance company goes to great lengths to know how much premium they need to charge and how many policies they have to write in order to be successful.
Sellers of options are the same way. A simple example that I sometimes use at a seminar to explain what I mean by the odds of success is this: the market can go in three directions — up, down, or sideways.
When an option is traded, the buyer of the option needs the market to go in one direction in order for that particular trade to be profitable. For example, if you purchase a put option you need the market to go down an amount greater than the premium in order for you to earn a profit on that option. The seller, on the other hand, earns his profit if the market goes up, stays flat or goes down less than the amount of the premium. On a purely statistical standpoint, the odds favor the seller of the option. Does that mean it’s foolish to be buying an option when the odds are against you? Please do not read that into this previous example. There is certainly much more than raw odds that come to play in the options market. We’ve been stressing throughout this course the concept of total investment trading and management.
Ignoring options because the odds favor the seller would be a terrible conclusion to draw. Seasonal factors as well as fundamental information significantly impact your odds as a buyer. You certainly don’t buy life insurance or health insurance based strictly on the odds. Most people buy them to protect themselves from catastrophic losses and to manage risk. Options are the same.
— Options are just one part of a Traders-total investment trading alternatives. They should seldom be used alone but rather should be integrated with the use of cash sales, forward contracting, and perhaps even some futures positions. — Options can even be referred to as a form of price insurance.– You have many choices available to you in considering the use of options. Among your choices are what contract month to select, the strike price you will use and the premium that you’re willing to pay.– Producers of a product will normally be the buyer of put options. Put options protect the farmer from falling prices by establishing a price floor. The price floor is determined by taking the strike price and subtracting premium and other costs. Basis levels must be accounted for as well. — Farming operations which require inputs of grain or livestock will often times use call options. A call option protects and establishes a maximum purchase price for a product. That maximum purchase price is determined by taking the strike price of the call and adding the premium and other related costs and adjusting for basis.– Other uses of puts and calls include covering grain in storage, hedging deficiency payments, and protecting forward contracts.
I hope you’ve enjoyed Session 1. Session 2 takes a more detailed look at premiums, specifically volatility and how it affects the premium of an option. Strike prices and breakeven will be discussed and what makes an option a good or a bad value. You’ll learn the profit (loss) aspects of options usage, and how that ties into a total marketing program. Session 2 is the second of four sessions in the course.