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Market Education

Hedging with grain futures

By using grain futures contracts, you establish a forward price for your crop. This may can be done anytime prior to when you expect to sell grain in your local cash market. For example, at planting time for wheat, you may decide to use futures to establish a forward price for the wheat you will sell at harvest. Or, you could use futures to price grain in storage that you will sell at some later date.

To be concrete, let's assume that today is April and you are planting your corn crop which you will harvest and sell in November in your local market. You have decided to forward price some of fall production. In April, you observe that the December corn futures price is $7.00 so you can lock-in that price by selling the December corn futures contract through a futures broker.

Once the contract is sold, you will be required to deposit margin funds with your futures broker to assure that you will adhere to the terms of the contract. If the price were to increase, your futures account would begin to lose money so you may need to send more money to cover the losses. Conversely, if the price falls, money will be added to your account.

The combination of your futures position and your sale of corn in the cash market will yield a net-price. This price takes into account any profits or losses on the futures position as well as the cash price received for corn. Let's now consider what happens in November to see what happens to your net-price for corn under different price scenarios.

Lower Prices in November

In November let's say the December corn futures price has fallen to $6.00. At this point in time, you offset the futures contract by simply buying back the December futures contract for a price of $6.00. Because you had originally sold the contract for $7.00 and you bought it back for a lower price of $6.00, you will earn a profit of $1.00 per bushel(less broker commissions and fees).

This profit of $1.00 can be applied to the price you sell corn for in your local market. Let's say that your local price for corn is $5.90 so your net-price is $6.90 ($5.90+$1.00).

Net-Price from Selling a December Corn Futures Contract at $7.00.
  Lower Prices in November Higher Prices in November
Profit on Futures $6.00 $8.00
December Futures +$1.00 -$1.00
Cash Corn Price $5.90 $7.90
Net Corn Price (cash price+futures profit) $6.90 $6.90

Higher Prices in November

What if instead of falling, the December corn futures price had been higher at harvest? Suppose that the December corn futures price is $8.00. You buy back your December contract at that price and have a loss of $1.00, which you would have already paid through any margin calls. At the same time, however, the price for corn in your local market will be higher because of the higher futures price. Let’s say your local price for corn at harvest is $7.90. Your net-price for corn is $6.90, which is simply your cash price of $7.90 less the loss on the futures contract of $1.00.

Net-Price is the Same

In either case, no matter whether the market moved higher or lower than what was contracted at $7.00, your net-price is still the same: $6.90. This occurs because the corn basis was always the same. The basis, which is the difference between the cash price and futures price, was -$0.10 no matter whether prices were higher or lower. In the real world, the basis may vary somewhat but it is usually easier to predict than price levels. Therefore, you can be reasonably confident of getting a specific price for your grain once you establish a price level using a futures contract.

Hedging with grain options

There are two important drawbacks to the use of futures contracts. First, futures contracts establish a forward price, but if prices later move to a more favorable level, you are stuck with the price you locked-in using a futures contract. Second, with futures contracts you must post margin funds and there is no limit to the amount that you can lose with a futures position.

Fortunately, options contracts provide away around both of these problems. Options contracts, which work like insurance that you would buy on your car or home, protect you against unfavorable price moves. For this insurance, you pay a premium to the option seller. The premium is the most that you can lose from the option position and does not require that you post margin funds to maintain the option position.

Defining an Option Contract

An option contract is simply a privilege conveyed to its owner. The owner (or buyer) of an option has the right to either buy or sell in the futures market at a specific price. There are two types of options, depending on whether the option owner has the right to buy or sell in the futures markets. A call option gives the owner the right to buy in the futures market at a specific price while a put option gives the owner the right to sell in the futures market at a specific price. The specific price that the option owner has the right to either buy or sell at is called the strike price of the option.

Like futures contracts, there are specific contract months for options. For example, in corn there are option contracts for March, May, July, September, and December. If you were to purchase a $6.50 March corn call option, then you would have the right (but not the obligation) to buy March corn futures for a price of $6.50 anytime between when you originally purchased the call option up until the option expires just prior to March.

The cost of buying the option is called the premium. The premium is the amount of money that the option buyer must pay the seller to receive the option and the rights it conveys. Option premiums vary throughout a trading day as the futures price changes. For any given contract month (e.g., March corn) there are numerous calls and puts traded with different strike prices. Examples of March corn options are given below for a specific trading day when the March futures price was $7.65. The option premium, which is quoted in cents per bushel and does not include commission charges, differs depending on whether the option is a put or a call, as well as the strike price. As stated earlier, the premium of the option is what changes on a day-to-day and minute-to-minute basis.

For example, a 720 March call option has a premium of 56.5 cents. Therefore, if you bought this option, you would have to deposit this amount of money in your futures account (plus commission) to cover the expense. On a 5,000 bushel contract for corn, this would amount to $2,825. However, unlike with futures, when you purchase an option there is no margin requirement.

Notice from the table above that call option premiums decrease as the strike price increases and, conversely, put option premiums decrease as the strike price decreases. Call options give the buyer the right to buy in the futures market at the strike price of the option. Therefore, because it is worth more to be able to buy at a lower strike price, lower strike price call options have higher premiums. Similarly, because it is worth more to be able to sell at a higher price, put options with higher strike prices have higher premiums.

Exercising Options and Option Pricing

With an option, the buyer has the right to either buy or sell in the futures market. This right is in effect until the option expires (called the expiration date) which usually occurs about one month prior to the delivery month. Before the option expires, the option buyer has the right to exercise the option and take the position in the futures market. For example, the buyer of a July $7.50 wheat put option could exercise the option (through his broker) anytime prior to June and would obtain a short July wheat futures position at a price of $7.50. If the July futures price was $7.10 at the time, then the futures position would have a $0.40 profit.

Although exercising an option is a possibility for the buyer, it is not necessary to exercise an option. This is because the option premium will reflect the value of being able to exercise the option. Therefore, it is possible to sell the option (as opposed to exercising it) to obtain a profit.

To understand option pricing, it is useful to consider some important terms.

Intrinsic Value --The amount of money that could be currently realized by exercising an option with a given strike price. A call option has intrinsic value if the current futures price is above the option strike price. For example, if a September soybean call option has a strike price of $13.25 and the September futures price is at $13.47, then the call option will have 22 cents in intrinsic value. A put option has intrinsic value if its strike price is above the futures price. For example, if a March corn put option has a strike price of $7.80 and the March corn futures price is at $7.67, then the put option has $0.13 in intrinsic value. When the option expires, the value of the option (whether a put or call), will be equal to the intrinsic value.

In-the-Money --A call or put option that has intrinsic value. For a call option, this is when the futures price is greater than the strike price. A put option is in-the-money when the futures price is less than the strike price.

Out-of-the-Money --A call or put option that has no intrinsic value. For a call option, this is when the futures price is less than the strike price while a put option is out-of-the-money when the strike price is less than the futures price.

Time Value--The time value of an option is the option premium less the intrinsic value. For example, in May let's assume that the December corn futures price is $6.80 and a December $6.70 call option is trading for $0.22. The call option has $0.10 in intrinsic value so the time value of the option is $0.12. As the name implies, the time value reflects the amount of time remaining until expiration.

The table below gives an example of how to compute the intrinsic value and the time value for call options. These prices are for the May corn contract and were taken in December, about 5 months from expiration.

The intrinsic value column is the difference between the current futures price ($7.62) and the option strike price. If this is negative, then the intrinsic value is zero. The time value is just the difference between the premium and the intrinsic value. Notice that the time value is highest for the $7.60 call option. This is because the $7.60 option is closest to the current futures price. Options that are either significantly in-the-money or out- of-the-money have lower time value because they have a lesser chance of being worthwhile to exercise.

Another important aspect to remember is that the premium of the option at expiration will be only the intrinsic value. Thus, if the futures price at expiration were $7.62 then the call option premiums would become the intrinsic value column and the time value column would be all zeros. Therefore, at expiration of the option, you will be able to sell the option for its intrinsic value.

Options and Insurance

Options contracts are very similar to insurance policies that you would buy on your home or car, for example. Like insurance, you buy option contracts to protect against an adverse price move. If you want to protect against declining grain prices, you could buy a put option which would provide insurance against lower prices.

Like buying an insurance policy, you must pay a premium to the seller. The seller is obligated to protect you in the event that you need price protection. If you own a put option to protect against falling grain prices and the futures price declines, then your put option will increase in value. This is like a payment from your insurance company to protect you from falling prices. If instead the prices increase, then your option will expire worthless and you will only lose the premium. In fact, the advantage of buying an option over using futures is that the most you can lose is the premium.

Using Put Options to Hedge Grain Sales

To protect against declining grain prices, you can use a put option as opposed to selling a futures contract. The put option gives you the right but not the obligation to sell futures any time prior to expiration. For this right, you must pay a premium which varies according to the strike price of the option, the futures price and the time to expiration of the option.

The advantages of using a put option instead of a futures contract is that the put option will limit your loss from higher prices and will allow you to earn a higher net-price if prices do in fact increase. With a put option, you will be able to set a price floor or minimum price for your grain. There is the possibility of getting a higher price if the futures price increases.

The price floor that you establish using a put option can be calculated from the following formula:

Price Floor = Strike Price of Put + Expected Basis - Put Premium.

To figure out the price floor, you simply take the strike price of the option, add the expected basis (cash price minus futures price) for the time when you expect to sell your grain, and subtract off the premium of the option.

As an example, suppose you wanted to establish a price floor for corn that you will sell at harvest time in November. You decide to use a December $5.70 put option. Currently, the December futures are trading at $6.39 and the premium for the $5.70 put option is $0.29. You estimate the basis is +$0.05 which is you best guess for the basis in November. Therefore, the price floor you establish by purchasing the $5.70 put option is:

Price Floor = $5.70 + $0.05 - $0.29 = $5.46

While $5.46 is the minimum price, there is still the possibility of achieving a higher price if the market is higher than $5.70 in November. To determine what your final net-price will be, you simply take the cash price in November and add any profit or subtract any loss from the options contract.

To illustrate, suppose November rolls around and the market has moved lower so that the December futures is at $5.32 and the cash price in your local market is $5.37 (giving the $0.05 basis). To determine your net-price, you must calculate how much you could sell your option for in November when the December futures is at $5.32. In November, the December option is going to expire so the option premium will consist only of intrinsic value. The intrinsic value for a $5.70 put option when the futures price is at $5.32 would be $0.38. Therefore, you would be able to sell your put option for $0.38 and you only paid $0.29 for it. The profit on your option contract would be $0.09. This $0.09 profit gets added on to your cash price of $5.37 to get a net- price of $5.46. Notice that this is the price floor. In fact, no matter how low the price goes, you will always get $5.46, as long as the basis is as expected. This is because as the market moves lower, the profits you make on the option contract will exactly offset the losses you suffer on the cash market.

What if instead of going lower, prices had gone higher? Let's suppose that in November the December futures is trading for $7.25 and the cash price is $7.30. Because the futures price is above the strike price of the put option, this option would expire worthless because there is no intrinsic value. Therefore, you would suffer a loss on the option of the $0.29 premium that was paid. However, the cash price is higher at $7.30 so your net-price is $7.01. Notice that this is higher than the price floor of $5.46 because the market was higher.

Choosing a Strike Price for Put Options

In the previous example, the put option used had a strike price of $5.70. However, there are usually a number of different options trading with different strike prices. How do you decide which strike price to use?

To answer that, we must first understand how choosing a different strike price will affect the price floor and the net price. Suppose instead of using the $5.70 put option we use a $5.80 put option for the December corn futures. Because the strike price is higher for the put option, this implies that the premium will be higher. Let's suppose the $5.80 put option is trading for $0.33. The price floor, which is the strike price plus basis minus premium, is:

Price Floor = $5.80 + $0.05 - $0.33 = $5.52.

Notice that this is higher than the price floor for the $5.70 put option. In that case, the price floor was lower at $5.46. Thus, with a higher strike price, you are able to set a higher price floor.

To see how the net price would be impacted by the choice of a higher strike price, we go through the same two price scenarios used earlier. In the first case, prices fall so that the December futures are $5.32 and the cash price is $5.37. The $5.80 put option will have $0.48 of intrinsic value so that is what you will be able to sell the option for at expiration. The cost of the option was $0.33 so the profit is $0.15 which brings the net-price up to $5.52. This, of course, is the price floor.

Consider what happens if instead the December futures price is $7.25 and the cash price is $7.30. Under this scenario, the futures price is higher than the strike price so the option would have no intrinsic value and would expire worthless. The $0.33 loss on the option would be deducted from the higher cash price to get a net-price of $6.97.

By using a higher strike price put option, you are able to set a higher price floor. However, there is a tradeoff because you do not benefit as much from higher prices. Notice that with the $5.80 put option, the net-price was $6.97 when prices were high but the $5.70 put option had a net- price of $7.01 under the same price scenario. The reason that a higher strike price option gives you a lower net-price when prices are high is from paying a higher premium. When prices are high, your option will expire worthless (because you do not need price insurance) so when you pay more for a higher strike price option, this lowers your net price.

Is there a right strike price to use? Not really. The choice of which strike price to use depends on your personal and financial situation as well as your expectations about where the market may be when your option expires. From a financial standpoint, your main objective may be to set a price floor above your costs of production. To do so, you may choose a high strike price put option to guarantee that the price you get will not fall below your production costs. On the other hand, you may believe there is a good chance that prices will be higher when your option expires, although you cannot afford a large loss. In this case, you may choose a lower strike price put option which will give you a better net-price if you prices are higher while maintaining some downside price protection if prices do fall.

Basics of Technical Analysis

Fundamental analysis relies on basic supply and demand data to project commodity prices. In contrast, technical analysis makes little to no use of fundamental commodity data, but instead relies on technical indicators about the price action in the market to project prices.

For technical analysts, the bar chart is probably the most valued tool for commodity futures trading. The bar chart is both a time and price chart. The choice of a time period for a bar chart depends on the length of time that a trend is trying to be identified. The most commonly used bar charts are daily and weekly bar charts are used to identify longer term trends than a daily bar chart.

For a daily bar chart, each bar represents the three most important prices for any given trading day:
  • 1.The highest point on the bar chart shows the highest price traded on a given day.
  • 2.The lowest point on the bar chart shows the lowest price traded on a given day.
  • 3.The closing price (also called the settlement price) is represented by a horizontal dash on the high-low bar.

Do charts and technical analysis really work? The common explanation is that charts work because traders make them work. If an uptrend breaks, “chartists” rush to sell. The resulting downtrend confirms the old rule to sell when an uptrend breaks.

Trend Lines

While charts make nice pictures, the real issue is whether they can be used to make profitable trading decisions. The most basic charting method is the trendline. In this section, we show how to use trendlines to spot markets that are trending higher and show how to identify markets that may be changing from upward to downward trending.

You draw an uptrend line using the most significant daily lows. Most significant means the lows that poke below the routine trading range. These lows represent the markets' attempts to go lower. When buying strength jerks prices back up into the uptrend that’s your sign there's still enough strength to maintain the uptrend.

The longer an uptrend line can be maintained without being broken, the more confident we are that the market will continue higher. Furthermore, the more times an uptrend line is tested and bounces higher from the line, the more significant is the uptrend. The image below shows the January 2013 Soybean contract in a clear uptrend, with the lows from 12/14/12 and 6/4/12 creating the slope of the trend line. This trend line was in place since June of 2012, so when prices started moving lower in September you would expect price support at the trend line.

Breaking An Uptrend

When an uptrend is broken, this is a good signal to sell because the market has lost its momentum to move higher. A broken uptrend line occurs when the market moves below the uptrend line. While this can occur by the low price penetrating the uptrend line, it is considered to be more significant when the closing price is below the trendline. After breaking an uptrend, a market may continue to move lower and eventually form a downtrend line. In many cases, however, the market simply stalls after penetrating the uptrend and may just move sideways for some time. The image below shows a broken uptrend in the S&P 500, followed by lower price action.

Identifying Markets Trending Lower

A down-trending market is signified by prices setting new lows with the daily high prices trending down. The downtrend line is drawn across the top of the most significant highs during the trend stage. As with the uptrend, the more times a market reaches the downtrend line, the more significant the trend.

When a downtrend line is penetrated to the upside, this signals a change in trend. Usually, the market will remain in a sideways trend for sometime before either moving higher on an uptrend or resuming a downtrend. When the downtrend line is penetrated, this is usually a good time to buy since the market has lost its momentum to move lower. Trendlines can be useful ways of identifying the market trend and possibly signaling a change in market trend. However, it is important to recognize that trendline analysis, as with any technical analysis, is not guaranteed. Therefore, if you see a situation where a market trend is changing based on trend line analysis, is important to support this conclusion with other indicators, whether fundamental or technical.