The following explanation and illustrations are an excerpt from CMEGroup’s publication, “Self-Study Guide to Hedging with Grain and Oilseed Futures and Options”. As an educational supplement, watch an example using a simple online hedge calculator in our newsletter. Take a quiz to help further your knowledge.
When it comes to choosing the option strike price, however, there is no easy rule of thumb. Your decision may be influenced by such considerations as: In your judgment, what is likely to happen to the price of the underlying futures contract? How much risk are you willing to accept? And (if your objective is price protection), would you rather pay a smaller premium for less protection or a larger premium for more protection? Options, with a wide range of strike prices, provide a wide range of alternatives.
The following brief examples illustrate how and why.
Example 1
Assume it is late spring and you would like protection against lower soybean prices at harvest. The November futures price is currently quoted at $8.50. For a premium of 25 cents, you may be able to purchase a put option that lets you lock in a harvest time selling price of $8.50 plus your local basis. Or, for a premium of 15 cents, you may be able to buy a put that lets you lock in a harvest time selling price of $8.30 plus the basis. If prices subsequently decline, the higher-priced option provides you with more protection; but, if prices rise, the savings on the cost of the lower-priced option will add another 10 cents (the difference in the premiums) to your net selling price. In effect, it is similar to deciding whether to buy an automobile insurance policy with a small deductible or a larger deductible.
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Example 2
Assume you decide to purchase a Corn call option for protection against a possible spring price increase. If the May futures price is currently $4.70 and you pay 8 cents for an out-of-the-money call with a $4.80 strike price, you will be protected from any price increase above $4.88 (strike price + premium). But, if you pay a premium of 15 cents for an at-the-money call with a strike price of $4.70, you will be protected from any price increase above $4.85 (strike price + premium). The out-of-the-money option, however, is cheaper than the at-the-money option – your out-of-pocket expense is the 8-cent premium (rather than the 15-cent premium) if prices decline rather than increase.
Example 3
In anticipation that wheat prices will remain steady or decrease slightly over the next four months, you decide to sell a call option to earn the option premium. If you are strongly bearish about the price outlook, you might want to earn a premium of 17 cents by writing an at-the-money $7.40 call. But, if you are only mildly bearish or neutral about the price outlook, you might wish to write an out-of-the-money $7.50 call at a premium of 13 cents. Although the premium income is less, the out-of-the-money call gives you a 10-cent “cushion” against the chance of rising prices. That is, you would still retain the full 13-cent premium if, at expiration, the futures price had risen to $7.50.
In each of these illustrations – and, indeed, in every option strategy – the choice is yours. The important thing is to be aware of the choices and how they affect the risks and rewards.
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