Hedging with Options

Remember the farmer who hedged his soybean crop and the refiner who hedged her gasoline sales? Let's look to see how options could enhance their hedging strategies. The farmer was concerned about soybeans dropping below $7 a bushel. When using futures he could lock in his price and protect himself from a price decline, but could not benefit if the market rallied. Options will allow him to participate in upside moves.

Instead of selling futures he can buy puts to protect a downside move. Assume the farmer purchases for $1, the August 7.00 soybean put, which expires when he plans to sell his crop. What are the possible outcomes of this strategy?

 

Scenario 1: The price declines to $5. At expiration the farmer will sell his put for $2, which is the intrinsic value of the option.

1. Profit from put = Sale price - purchase price

                          = $2.00 - $1.00

                          = $1.00

2. Loss from soybeans = $5.00 - $7.00

                                 = -$2.00

                           Net = $1.00 - $2.00

                                 = -$1.00

The put will effectively allow him to sell the soybeans at $6. If the farmer wanted to protect his position from dropping below $7, as in the futures example, he could purchase a higher strike put such as the 8.00 or 9.00 strike. The price of these puts would be more but they would offer more downside protection. For example, assume the 8.00 strike put was trading at $1.50 and the 9.00 strike put was trading at $2.25. The 8.00 and 9.00 strike put would effectively make him short at $6.50 and $6.75, respectively.

 

Scenario 2: The price rises to $10. The farmer will now be able to participate in any upward price move, unlike the outright futures. If soybeans rally to $10 he will be able to sell his soybeans for $10, but the puts will expire worthless. For example:

1. Loss from buying put = purchase price of put

                                   = -$1.00

2. Profit from soybeans = $10.00 - $7.00

                                   = $3.00

                           Net   = $3.00 - $1.00

                                   = $2.00

The farmer will be able to make an extra profit of $2. In fact, he will be able to participate in any upmove greater than the purchase price of the put. If soybeans should go even higher to $12 he will make an extra $4.

 

Scenario 3: The price remains at $7. The farmer will lose $1 on the put which will expire worthless, and sell his soybeans at $7. He will lose $1 in this case.

Options expand his hedging possibilities considerably. Using spreads will provide even greater flexibility. For example, the fence is a popular hedging vehicle. Recall, that the fence is buying a call and selling a put with different strikes (or selling a call and buying a put with different strikes). Let's see how Rose can use a fence to enhance her hedging possibilities.

Rose was concerned that the current price of gasoline which was at $0.45 might rise above $0.50 a gallon in December. She will make a $0.05 profit if the price is $0.45 a gallon, but breakeven if the price is $0.50 a gallon. She could buy calls to protect herself against a price rise. She could also buy the December 50 call-40 put fence.

 

1. Assume the December 50 call and 40 put are both trading at $0.01.

2. Assume the December 48 call is trading at $0.02.

 

Rose could buy the December 48 call for $0.02 which would effectively protect her from any price rise above $0.50.

 

Scenario 1: The price rises to $0.50.

1. Breakeven on the call = $0.02 - $0.02

                                    = $0.00

2. Breakeven on the gasoline = $0.50 - $0.50

                                           = $0.00

 

She will breakeven on the transaction if gasoline rises anywhere above $0.48 a gallon. For example, if gasoline rises to $0.48 a gallon she will lose $0.02 on the call, and make $0.02 on selling the gasoline for $0.50 a gallon.

 

Scenario 2: The price drops to $0.40.

1. Loss on the call = purchase price = -$0.02

2. Profit on the gasoline = $0.50 - $0.40

                                   = $0.10

She will do considerably better and make $0.08 a gallon instead of her originally expected profit of $0.05.

 

Scenario 3: The price remains the same.

1. Loss on the call = -$0.02

2. Profit on the gasoline = $0.50 - $0.45

                                   = $0.05

 

She will make $0.03 a gallon which is less than anticipated, hut remember, she is now protected from any price increase. She has in essence paid an insurance premium or the price of the option for this protection.

How would a fence change her profit and loss opportunities? Assume she bought the December 50 call for $0.01 and sold the December 40 put for $0.01. She would be buying the fence for even money. Her profit and loss possibilities follow:

 

Scenario 1: The price rises to $0.50.

1. Lose $0.01 on the call, but make $0.01 breakeven on the fence.

2. Breakeven on the gasoline.

She will breakeven above $0.50 a gallon.

 

Scenario 2: The price falls to $0.40.

1. Breakeven on the fence again.

2. Profit from the gasoline = $0.50 - $0.40

                                      = $0.10

She will make a $0.10 profit on the transaction.

 

Scenario 3: The price remains the same.

1. Breakeven on the fence again.

2. Profit from the gasoline = $0.50 - $0.45

                                       = $0.05

 

She will make a $0.05 profit on the transaction.

Notice how the fence has enhanced her profit opportunities versus buying the call outright. However, if the price of gasoline drops below $0.38, the outright purchase of the call would prove more profitable.

These are a few of the many strategies which can be employed when hedging with options. There are many other strategies which are particular to the market and hedger. As in speculating there is no good or bad strategy with options, but instead, a set of opportunities which should enhance the profit possibilities of the intelligent hedger, no good or bad strategy with options, but instead, a set of opportunities which should enhance the profit possibilities of the intelligent hedger.