Commodity options

Working of options
Option buyers have the right to buy and sell the underlying asset Option buyers are not obligated to buy and sell the underlying instrument Option sellers are obligated to deliver the underlying asset (call), or take the delivery of underlying asset, at strike price of the option ,regardless of the current price of the underlying asset ,if the option is exercised. Options are good for a specified period of time ,after which they expire. Options are available in several strike prices representing the price of underlying instrument The cost of option is referred to as option premium The premium reflects variety of factors ,including the current price of the underlying asset , the strike price, time remaining until expiry ,and volatility

Choosing which option to buy or sell Call Put

Bullish Right to buy Pays premium buy Restricts losses Potentially unlimited profit Bearish Obligation to sell Receives premium Limited profits Potentially unlimited losses Bearish Right to sell Pays premium Restricts losses Potentially unlimited profits Bullish Obligation to buy receives premium Limited profits Potentially unlimited losses

sell

Terminology
Option class Option series Moneyness of an option Option styles (European generally cheaper than American)
Call option Put option

In-the-money

S>K

S<K

At-the-money

S=K

S=K

Out-of-themoney

S<K

S>K

Working of options
The length of the option (All else being same longer option commands a higher premium) The options strike price The relationship between the strike price of an option and the current price of underlying future contract ,length of option affects option premium Call Option with lower strike price will have higher premium cost Put option with a higher strike price will cost more to purchase than a put option with a lower strike An option with more time to expiry will have greater chance of being profitable before expiry, but will command higher premium

Buying the option

(requires assessment Break even price of different alternatives with different strike prices and length of time to expiry ) Premium cost Options strike price Commission and other transaction costs For a call option Break even price = option strike price +option premium+ commission and transaction cost For a put option Option strike price premium- commission and transaction costs

Example
In April gold contract is trading at around Rs 15,000 for 10 grams .A trader expects that over the next several months there may be significant price increase and April Gold futures will rise significantly above its present level. To profit , the trader is considering buying a call option with a strike price , say ,Rs 15,200 for 10 grams. Assume that the premium for that option is Rs 500 for 10 grams (A total of Rs 50,000 for 1kg gold contract) and that the commission and other transaction costs will be Rs 2 per 10 grams (Rs 200 for a 1 kg contract) Break even price = Rs 15200+Rs 500 +Rs 2 =Rs 15,702

For a put option

The price of gold is currently just above Rs 15,000 per 10 grams ,but ,during the next few months, the trader expects a sharp decline in gold prices. To profit from the price decrease if it occurs, he is considering the purchase of a put option with a strike of Rs 15,000 per 10 grams. Assume the premium for this particular option is Rs 40 per 10 grams ( a total of Rs 40,000 for 1 kg contract), and commission and transaction costs are Rs 3 per 10 grams (Rs 300 for a 1 kg contract) Breakeven price =15,000-40-3 =Rs 14957

One the trader has bought an option ,then, at any time prior to the expiry the option, he can;
Exercise the option: the buyer will acquire long or short position in underlying future contract. Result will be: A cash margin will need to be deposited in order to provide protection against possible fluctuations in the future price If the future prices moves adversely to the traders position, additional cash margin deposits will be called in Unlike buying a call or a put option which has limited risk, a futures position has potentially unlimited risk. Only a small percentage of option buyers elect to realise option trading profits by exercising an option. Most choose having an brokers offset I.e liquidate the option at currently quoted premium

 It is an option to reduce loss in case future price does not perform as expected, or if the price outlook has changed The amount the option will sell for will depend primarily on: The current futures price in relation to options strike price, and The length of time remaining until expiry of the option Net profit or loss after allowance for commission and other transaction costs will be premium paid and received There is no guarantee that there will be an active market at the time of liquidating the options The individuals who bought these options from you may have been offsetting a previously established short positions in the calls or may be establishing a new long position in them Continuing to hold the option

One the trader has bought an option ,then, at any time prior to the expiry the option, he can; Liquidating the option:

Example
Take the case of trader who acted in anticipation of rising gold and bought a call option on 1kg gold Futures contract. The premium cost was Rs 50,000 and commission and transaction costs were Rs 200.Gold prices have subsequently risen and now command a premium of Rs 55000.What is traders net gain by liquidating the option Rs 4600

Margin requirements
Option writers are required to post margin to fulfill contract obligations When required margin exceeds posted margin , writer will receive a margin call. Holder of the option need not post a margin Out money requires less margin Margin requirements are determined in part by other securities held in investors portfolio If the underlying security is not owned, it is determined by the value of the underlying security as well as by the amount by which option is in or out of the money

Margin Calculation
The loss and gains are difficult to estimate in case of options, the financial risk is estimated by the clearing house by using a computer software : standard portfolio analysis of risk (SPAN). The basic method is to compute the loss for a given range of prices on the next day, given the current days price for underlying asset. This is Risk margin. Premium margin: it is the amount of premium the writer would receive for the options they have written. Assignment margin:The clearing house imposes a margin for any assignment in case of exercise of option before maturity date.

Example
Call options are available on the bank Nifty index on sep-1st with expiry on sep-24th . The value of the bank nifty index on Sep-1 is 7377.20. the option premium is Rs. 153 for the bank nifty call option with an exercise price of 7600. you write 5 options. The margin a/c will be as shown below, assuming that you would close out the position on Sep-5th . Since the multiplier is 50, the total premium is market premium*50.

Premium margin (in INR) Day

Option premium premium/contract premium margin for 5 contracts

1
153 7650 28,250

2
185 9250 46,250

3
210 10,500 52,500

4
245 12,250 61,250

5
318 15,900 79,500

Risk margin & total margin in INR Day Option premium Upside theoretical price Downside theoretical price Risk margin/contract Risk margin for 5 contracts Premium margin for 5 contracts Total margin 1 153 162 141 450 2250 28,250 30,500 2 185 197 168 600 3000 46,250 49,250 3 210 225 195 750 3750 52,500 56,250 4 245 270 208 1250 6250 61,250 67,500 5 318 350 286 1600 8000 79,500 87,500

The risk margin is calculated as (upside theoretical price- current option premium)* contract multiplier. E.g. for the 1st day, risk margin= (162-153)*50= 450. The premium margin = current option premium* contract multiplier. Total margin= Premium margin + Risk margin

The Arithmetic of option premium

Premium = Intrinsic value+ time value Intrinsic value or monetary value

Intrinsic value - profit that could be made if the option was immediately exercised
Call option = max(S-K ,0) Put option: max(K-S,0) At money : No intrinsic value ,only time value ITM= positive intrinsic value and time value OTM = no intrinsic value

Time value of an option

Value of not exercising the option immediately. Time value of an option is nothing but the sum of money that option buyers are presently willing to pay for specific rights that a given option conveys. The amount option buyers are willing to pay for possible increase in stock price over time Time value depends on the variability of stock price and time remaining until maturity Time value is maximum when call is at money and it is near to zero for deep in the money and deepout-of money options

Call Option Value before Expiration

Factors that affect options time value

Time remaining until expiry Relationship between the option strike price and current price of the underlying futures contract Volatility (option time value and premiums are higher in volatile markets)

Selling options
Seller will make money Move favorable to sellers position Market remain stationary and quiet Market moves ,but to a lesser degree than premium received

Pricing options
Change in the price of underlying asset Strike price Time until expiry Volatility of the underlying asset Risk free interest rate

Determinants of Call Option Values

Effect of Variables on Option Pricing

Variable
S0 K T r
c: p: C: P:

+ ? + +

+ ? +

+ + + +

+ + +

European call option price European put option price American Call option price American Put option price

Effect of volatility
Call option values also increase with the volatility of the underlying stock price. Consider circumstances where possible stock price may range from $10 to $50 compared to a situation where stock prices may range only from $20 to$40.In both cases avg stock price is $30.Strike price is $30 What are the payoffs?

Effect of volatility
High volatility scenario Stock 10 20 price Option 0 0 payoff Low volatility scenario Stock 20 price Option 0 payoff 25 0 30 0 40 10 50 20

30 0

35 5

40 10

Effect of volatility
Assume equal probability of 0.2 Expected payoff in high volatility scenario=$6 Low volatility condition = $3

Practical observations on commodities market

Spot commodity prices exhibit mean reversion Future commodity prices have instantaneous volatilities Jumps are much larger in magnitude than other markets Shorter dated futures prices jump by a large amount but long dated contracts hardly jump at all

Time decay
Options have a fixed expiry date Options are wasting assets Time decay accelerates in last 30 days before expiry Time decay in favor of option writers and against option buyers The more time an option has to expiry ,the more time value it will have Theta Detriment to option buyer and to benefit of option seller (time value declines and probability that option would become profitable reduces)

Time decay
Time decay from day 120 to day 90(least impact)

Time value Option premium

Time decay under 30 days prior to Expiry (most rapid)

Days to expiry 120 90 30 0

Put Call Parity

If the prices are not equal arbitrage will be possible X C S0 P T (1 rf )

Put Call Parity

Call option Value of riskless bond Total

St<=X 0 X X

St>X St-X X St

Put Call Parity - Disequilibrium Example

Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 5% Maturity = 1 yr X = 105 X C S0 P T (1 rf ) 117 > 115 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative

Table 20.5 Arbitrage Strategy

Put-Call Parity
Assumptions: Strike price should be the same Maturity period should be the same Consider the following 2 portfolios: Portfolio A: European call on a stock + PV of the strike price in cash Portfolio C: European put on the stock + the stock Both are worth max(ST , K ) at the maturity of the options They must therefore be worth the same today. This means that

c + Ke -rT = p + S0

Arbitrage opportunities
Suppose that the Stock price is$31 , the strike price is $30 , the risk free interest rate is 10% p.a. , the price of the three month European call option is $3 , and the price of a three month European put option is $2.25.In this case , c + Ke rT = 3+30 e-0.1*3/12 =$32.26(Portfolio A) and p + S0 =2.25+31= $33.25 (Portfolio C) Portfolio C is over priced relative to portfolio A Action Now Short portfolio C and long portfolio A Buy call for $3 and Short put for $2.25 and sell stock for $31 Cash flows = -$3+2.25+31= $30.25 When invested at the risk free interest rate , this amount grows to $30.25 e0.1*0.25 = $31.02 at the end of 3 months

Arbitrage opportunities
Actions in 3 months if ST >30 Receive $31.02 from investment Exercise call to buy stock for $30 Put option will not be exercised Net profit = $1.02 Actions in 3 months if ST <30 Receives $31.02 from investment Call option will not be exercised Put exercised : buy stock for $30(short on put ) Net Profit =$1.02

Exotic option
Plain vanilla Vs OTC Flexibility Most developed in foreign exchange market In commodities in crude oil , natural gas ,precious metals ,base metals Relatively inexpensive Bermudan option Asian option (eg. Asian call option may have payoff equal to avg. stock price over last 3 months minus the strike price)

Exotic options
Barrier option (knock in and knock out option) (double vs single barrier option) Cheaper than plain vanilla counterparts Rainbow option Look back option (a look back call option provide payoff equal to maximum stock price during the life of the option minus the strike price ,instead of final stock price minus the strike price) Ladder option(step lock option) Binary/digital /bet option(cash-or- nothing and assetor- nothing) Quanto option Weather option

Exotic options
Compound options Eg a call on call .On the first exercise date ,T1, the holder of the compound option is entitled to pay first strike price ,K1, and receive a call option.The call option gives the holder the right to buy the underlying asset for the second strike price ,K2, on second exercise date T2 Shout option

Value of a Protective Put Positions

Value of a Protective Put Position at Option Expiration

Protective Put versus Stock Investment (at-the-money option)

Value of a Covered Call Position at Expiration

Value of a Covered Call Position at Expiration

Covered calls and Protective puts

Naked Options Writing a covered call :Figure (a) Long position on a stock +short position in a call option Reverse of writing a covered call : Figure (b) Short position in stock +long position in a call option Protective put strategy :Figure (c) long stock + Long put Reverse of a protective put: Figure (d) Short position in a put option +short position in stock

Positions in an Option & the Underlying

Payoff like short put option Payoff like long put option

Profit

Long stock

Profit
Long call

K K
(a) Profit

ST
Short call

ST
(b)
Short stock

Long stock

Profit
Short put

K
Long put

ST

K
(d)

ST

(c)
Pay off like long call option

Short stock Pay off like short call option

Profit patterns with put call parity

p + S0 = c + Ke -rT
Protective put has profit pattern of long call Reverse protective put has profit pattern of short call Rearranging the equation S0-c = Ke -rT p Covered call has profit pattern like short put Reversing covered call =long put

Straddle(combinations)
Combination of a purchasing (long) or selling (short) a put and a call on the same expiration Betting on a large price movement (long straddle) or little price movement (short straddle) Bottom straddle or straddle purchase Stock price near strike price leads to loss, movement in the either direction leads to significant profit

Max loss when ST = strike

Top straddle or straddle write (reverse position) Pay off from a straddle Range of stock prices ST<=K ST>K Payoff from a call Payoff from put 0 ST-K K-ST 0 Total payoff K-ST ST-K

Value of a Straddle Position at Option Expiration

A straddle is appropriate when an investor is expecting a large move in a stock price but does not know in which direction the move will be. (Bottom straddle or straddle purchase) A top straddle or straddle write is the reverse position. Created by selling a call and a put with same expiration date and same exercise price. If the stock price is close to strike price on expiration date, significant profit results Loss arising from large move is unlimited

Value of a Straddle at Expiration

A Straddle Combination Bottom straddle or straddle purchase

Profit

ST

Example
Total cost : Option premium paid Maximum loss: option premium paid Maximum profit : Unlimited Expecting volatile wheat price over next three months , a trader simultaneously buys a Rs 12,000 put at a premium of Rs 410 per tonne, and a Rs 12,000 call also at a premium of Rs 420 per tonne Total premium cost Rs.830 At any price within Rs 11170 and Rs 12830 range other than exactly Rs 12000- a portion (but not all) of Rs 830 premium costs will be recovered by offsetting the in-the money option and allowing the out-of money option to expire worthless

Selling a straddle
Total receipt : option premium received Maximum loss: unlimited Maximum profit : option premium received Assume one earns a Rs 410 premium by writing a Rs 12000 put ,and an additional Rs 420 premium by writing a Rs 12000 call total premium received is Rs 830.Ifthe futures price at expiry is between Rs 11170 and Rs 12830 , the short straddle position will realise a net profit If future price at expiry is Rs 11,900, the call and put buyers will allow the option to expire worthless and writer retains the premium.

Strip & Strap (combinations)

Long position in two calls and one put Increase in stock price more likely

Profit

Profit

K Strip

ST

K Strap

ST

Long position in one call and two puts Large price move but decrease more likely than an increase

PROFIT FROM A BOUGHT STRIP POSITION

Assume that a Reliance share is currently selling for INR 2,750 and has a call as well as a put option on it, with an exercise price of INR 2,800 and an expiry of 90 days. The price of the call is INR 50, and the price of the put is INR 100. What are the gain from a bought strip when Stock price is 2600,2650,2700,2750,2800,2850,2900,2950,3000,3050,3100,3150,3200 Solution: The investor with a bought strip will make a loss as long as the stock price is in the range of INR 2,675(2800-250/2) where 2 puts would be exercised to INR 3,050(2800+250),where a call would be exercised They will make a profit if the stock price goes below INR 2,675 or above INR 3,050. Moreover the profit from a strip is larger when the price decreases below INR 2,650.Thus a bought strip is preferable when the probability of an increase in the downward movements of stock prices is higher. The strip buyer will also benefit if the stock price increase beyond INR 3,050.

PROFIT FROM A BOUGHT STRIP POSITION

STOCK PRICE(INR) GAIN FROM THE BOUGHT CALL (INR) GAIN FROM THE TWO BOUGHT PUTS(INR) GAIN FROM THE STRIP(INR)

2600 2650 2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200

-50 -50 -50 -50 -50 0 50 100 150 200 250 300 350

200 100 0 -100 200 200 200 200 200 200 200 200 200

150 50 -50 -150 -250 -200 -150 -100 -50 0 50 100 150

PROFIT FROM A WRITTEN STRIP POSTION

Assume that a Reliance share is selling is for INR,2750 and its has a call as well as put option on it, with an exercise price of INR,2800 and an expiry of 90 days. The price of the call is INR 50, and the price of the put is INR 100. Find the profit the written strip when Stock price is 2600,2650,2700,2750,2800,2850,2900,2950,3000,3050,3100,3150, 3200 Solution: A written strip results in a profit when the stock price is in the range of INR 2675 to INR 3050. Thus a written strip strategy is preferable when the stock price is expected to be steady and not likely to move in either direction and when the movement , if any, is expected to be upwards, rather than downwards.

PROFIT FROM A WRITTEN STRIP POSTION

STOCK PRICE(INR) GAIN FROM GAIN FROM THE WRITTEN THE TWO CALL (INR) BOUGHT PUTS(INR) 50 50 50 -50 -100 -200 0 200 200 200 GAIN FROM THE STRIP(INR) -150 50 250 150 100

2600 2700 2800 2900 2950

3000
3050 3100 3150 3200

-150
-200 -250 -300 -350

200
200 200 200 200

50
0 -50 -100 -150

PROFIT FROM A BOUGHT STRAP POSITION

Assume that a Reliance share is currently selling for INR 2750 and it has a call as well as a put option on it with an exercise price of INR 2800 and an expiry of 90 days. The price of the call is INR 50 and the price of the put is INR100. Show the profit from this bought strap strategy when stock prices are 2400,2500,2600,2700,2800,2900 and 3000 respectively. In a bought strap strategy the investor will make a profit as long as the stock price is above INR 2900(2800+50*2) or below INR 2600(2800-200), they will make losses if the stock price is within the range of INR 2600 to INR 2900 Thus a bought strap is more beneficial if the price are expected to have substantial upward movement.

PROFIT FROM A BOUGHT STRAP POSITION

STOCK PRICE (INR) GAIN FROM THE GAIN FROM TWO BOUGHT BOUGHT PUT CALLS(INR) (INR) -100 -100 -100 -100 -100 100 300 200 100 0 -100 -100 GAIN FROM THE STRAP(INR)

2400 2500 2600 2700 2800 2900

200 100 0 -100 -200 0

3000

300

-100

200

PROFIT FROM A WRITTEN STRAP POSITION

Assume that a Reliance share is currently selling for INR 2750 and it has a call as well as a put option on it with an exercise price of INR 2800 and an expiry of 90 days. The price of the call is INR 50 and the price of the put is INR100. Show the profit from this written strap strategy when stock prices are 2400,2500,2600,2700,2800,2900 and 3000 respectively This position will result in profits the stock price is in the range of INR 2600 and INR 2900. If the stock price increases beyond INR 2900 this strategy will result in the substantial losses. Thus a written strap is advantageous when the stock price is likely to remain in the close range of the exercise price and the chances of is going down slightly more than the chances of it going up

PROFIT FROM A WRITTEN STRAP POSITION STOCK GAIN FROM PRICE (INR) THE TWO SOLD CALLS(INR) 2400 100 GAIN FROM SOLD PUT (INR) GAIN FROM THE STRAP(INR)

-400+100=-300

-200

2500 2600
2700 2800 2900 3000

100 100
100 100 -200+100=-100 -400+100=-300

-300+100=-200 -200+100=-100
100-100=0 100 100 100

-100 0
100 200 0 -200

Strangles
Bottom vertical combination (buys a put and a call with same expiration date and different strikes) The call strike ,K2 is higher than put strike price, K1 The profit pattern depends on how close together strike prices are. Larger the distance less downside risk and farther the stock price has to move. Downside risk less than straddle Top vertical combination (sale of a strangle) Range of stock price ST<=K1 K1<ST<K2 ST>=K2 Payoff from Payoff from Total payoff call put 0 K1-ST K1-ST 0 0 0 ST-K2 0 ST-K2

A Strangle Combination

Profit K1 K2 ST

Question
A stock is currently valued at $69 by the market.It is expected to move significantly in next three months.A call costs $4 and the put costs $3.An investor buys both call and put with strike price of $70 Identify the strategy and net profit / loss to the investor if stock price is a) $69 b) $70 c) $90 d) $55

Hedging for buyer

Long calls Call options on exercise will yield long future position Limited liability with no margin deposits Futures cannot alone provide this combination of upside price insurance and downside profit potential Maximum (ceiling) buying price = call strike price +premium paid +/- basis

Hedging for buyer

Assume a flour maker who needs to establish a wheat purchase price for late November flour delivery. The time is August and the December wheat futures price is Rs 12,000 per tonne.(The December contract is chosen because it most closely follows the planned time to give delivery of the product). At this level ,the flour maker decides to use options to protect his wheat purchase price and the related profit margins against a rise in the price of wheat.

Call(1) 11900 12000

Premium(2) 440 430

Hedging for buyer

Basis(3) 300 300

Ceiling price (1+2-3) 12040 12130

Hedger will pay max ceiling price =12000+430-300 =12130 Assume the December future price has risen to Rs 12,450 Call option strike price 12000 can be sold for an intrinsic value of Rs 450 Premium paid = 430 Net price paid= 12000-300 +430 (If option is exercised) OR =12450-300+430-450(If option is offset) What if futures price decreases to 11,550 ? Local price = Rs 11,250 Net price paid for wheat =11250+430=11680 OR 11550-300+430 =11680

Hedging for buyer

Net price for the basic ingredient ( whether price has gone up or down)/net purchase price = Futures price when commodity is purchased/sown+/- local basis at the time of purchase+ premium paid for the optionpremium received when option offset (if any)

Result of long Rs 12,000 December wheat call at Rs 430 per tonne premium
Dec wheat future prices (1) 11550 11700 11850 12000 12150 12300 12450 Basis(2) Local Mandi Price (3)=(1-2) 11250 11400 11550 11700 11850 12000 12150 Long futures gain()/Loss(+)(4) 430 430 430 430 280 (430-150) 130 20 Effective buying price(5)=(3)+/-4 11680 11830 11980 12130 12130 12130 12130 -300 -300 -300 -300 -300 -300 -300

Hedging for buyer

Breakeven price =Rs 12430 Ceiling or maximum buying price =12130 After the buyer has purchased the option contract may be handled in 3 ways: Exercise the call option Let the call expire Offset the call option

Selling the put option

A commodity buyer can lower the purchase price of his inputs by amount of premium received Selling options also involve margin funds to be kept with broker If the prices fall below the strike price ,there is a possibility that put seller will be exercised against and assigned a long future position at any time during the life of option position Minimum (floor) buying price = put strike price premium received +- expected basis

Selling the put option

Assume a flour maker who is a wheat buyer , needs to lock in a price for mid- November delivery. It is August, Dec wheat future price is Rs 12000 per tonne ,and flour maker expects wheat prices to trade in narrow range.(Dec contract is chosen because it most closely follows the planned time to take delivery of input). Also , assume out-of- money December wheat puts (strike price of Rs 11800) are trading at Rs 420 per tonne.The basis is Rs 300. The flour maker decides to sell December Rs 11800 puts to reduce the actual price he will pay for wheat between now and November. Minimum (floor) buying price =11800-420-300=11080 The effective buying price will depend on actual futures price and basis

Result of short 11800 December wheat put at Rs 420 per tonne premium
Dec wheat future prices (1) Basis(2) Local Mandi Price (3)=(1-2) short futures gain()/Loss(+)(4) Effective buying price(5)=(3)+/4

10900
11050 11200 11350 11500 11650 11950

-300
-300 -300 -300 -300 -300 -300

10600
10750 10900 11050 11200 11350 11650

(480)
(330) (180) (30) 120 270 420

11080
11080 11080 11080 11080 11080 11230

Selling the put option

If the prices fall loss on put offsets the benefits of falling spot market If market price rises , upside protection is limited to the amount of premium collected.

Buying a call option and selling a put option (long call and short put)
Provides buying price range Purchasing call option creates ceiling price and selling a put establishes a floor price The hedger effectively lowers the price by selling the put Lower strike price for the put option (i.e floor price) and higher strike price for call option (i.e. ceiling price)

 Assume again a flour maker is buying wheat for his mill and decides to use wheat options to establish a price range for requirements between August and November. December futures are at Rs 12,000 a tonne, and the expected basis is 300 .The flour maker decides to establish a buying price range by purchasing a Rs.12000 (at-the money) call for Rs 430 and selling a Rs 11,800 (out-of-the-money) put for Rs 420 Net premium Rs 10 Maximum ceiling purchase price = 12000+430-420300=11710 Minimum purchase price = 11800+430-420-300 = Rs 11,510 A small difference in price will result in narrower purchase price range

Buying a call option and selling a put option (long call and short put)

Result of long Rs 12000 December wheat call at 430 per tonne premium and short Rs 11800 December wheat put at Rs 420 per tonne premium
Dec wheat future prices at time of offset (1)
11600 11650 11700 11750 11800 12150

Basis(2) Local Mandi Price (3)=(1-2)

-300 -300 -300 -300 -300 -300 11300 11350 11400 11450 11500 11750

12000 long call (right to buy when price rises)

-430 -430 -430 -430 -430 -280

11800 short Net purchase price put (obligation to buy when prices fall)
220 270 320 370 420 420 11510(put strike+pr paidpr recd +- basis) 11510 11510 11510 11510 11710

12200

-300

11900

-230

420

11710(call strike +pr paidpr recd+-basis)

Long call combined with short put

Net Purchase price

December futures price

Hedging for seller

Buying the put options Take the case of a wheat producer whose crop has just been planted. His concern is that there may be a sharp decline in prices by harvest in late March. At present , The April futures price is Rs 12,500 per tonne.Basis is Rs 100 If the April futures price in March is Rs 12,500 per tonne, mandi transaction will take place at Rs.12,400 per tonne Min floor selling price =put strike premium paid+/Expected basis

Hedging for seller

Put(1) 12500 12600 Premium(2) 430 440 Basis(3) 100 100 Floor price (1-2-3) 11970 12060

Whether the price increases or decreases: Futures price when farmer sells crop+/- local basis at the time of salepremium paid for the option +Option value when option offset (if any)= Net selling price

Result of long Rs.12,500 April wheat put at Rs 430 per tonne premium
April wheat future prices (1)
11500 11600 11700 11800 11900 12000 12100

Basis(2)

Local Mandi Long futures Price (3)=(1-2) gain(+)/Loss()(4)

11400 11500 11600 11700 11800 11900 12000 570 470 370 270 170 70 -30

Effective selling price(5)=(3)+/-4

11970 (put strike+- local basis premium paid) 11970 11970 11970 11970 11970 11970

100 100 100 100 100 100 100

12200

100

12100

-130

11970

Selling call options (short call)

This strategy locks in a maximum selling price level If the futures market price increases above the call strike price , the farmer will be able to sell the commodity at a better price If the market rallies above the call strike price by an amount greater than premium collected , the losses on short call will outweigh the increased spot selling price

Example
Take the case of the same wheat farmer . To augment the selling price , he decides to sell the Rs 12700 April wheat call option (out-of-the money) for a premium of Rs 400 per tonne. Expected maximum selling price= 12700+400-100 = Rs 13000

Result of short Rs12,700 April wheat call at Rs 400 per tonne premium
April wheat future prices (1) 11500 12000 12500 13000 13500 Basis(2) Local Mandi Price (3)=(12) 11400 11900 12400 12900 13400 short futures gain(+)/Loss()(4) 400 400 400 100 -400 Effective selling price(5)=(3)+/4 11800 12300 12800 13000 13000

100 100 100 100 100

Buying a put and selling a call

Short hedging strategy Continuing with the example where a wheat grower who has just completed, sowing in November ,and being concerned that prices will decline between sowing and harvest, buys a put with a strike of Rs 12500 put at a premium of Rs 430 a tonne.While the farmers is now protected against losses if prices of wheat do fall at harvest time ,he is also free to make profits if prices rise If option premium is high combination or fence strategy can be used Farmer opts to buy at- the money Rs 12,500 put at a premium of Rs 430 a tonne,and sells an out-of-the- money call with a strike of Rs 12700 for a premium Rs 400 a tonne. Net premium paid = Rs 30 Floor price =12500-430+400-100= Rs 12370 Ceiling price =12700-430+400-100 =12570

Results long Rs 12,500 April wheat put at Rs 430 per tonne premium and short Rs 12700 April wheat call at Rs 400 per tonne premium
April wheat future prices at time of offset (1) 11500 12000 12500 13000 13500 14000 Basis(2) Local Mandi Price (3)=(1-2) 12500 put gain/loss 12700 call gain/loss Net selling price

100 100 100 100 100 100

11400 11900 12400 12900 13400 13900

570 70 -430 -430 -430 -430

400 400 400 100 -400 -900

12370 12370 12370 12570 12570 12570

Choices for commodity buyers

Commodity price outlook strategy

Volatile and bullish

Stable and bullish Volatility undecided and bullish

Long call (max ceiling buying price)

Short put (Min floor buying price) Long call and short put

Choices for commodity sellers

Commodity price outlook strategy

Volatile and bearish

Stable and bearish

Long put (min floor selling price)

Short call (Max ceiling selling price)

Volatility undecided and Long put and short call bearish

Option Spreads
Many other option strategies can be crafted using combinations of option positions Price spread (vertical spread)
Buying and selling options on the same stock with the same expiration, but with different strike prices

Time spread (horizontal or calendar spread)

Buying and selling options on the same stock with the same strike price, but with different expirations Diagonal Spreads

 Bullish spreads Buy a lower priced option and sell a higher priced option on the same stock Bull spread using calls(buy call option at certain strike price and sell on the same stock with a higher strike) Bull spread created from calls requires an initial investment (Pr paid> Pr. Recd.)

Option Spreads

Stock price range ST<=K1 K1<ST<K2 ST>=K2

Payoff from long call option (K1) Zero ST-K1 ST-K1

Payoff from short Total payoff call option(K2) Zero Zero -(ST-K2) Zero ST-K1 K2-K1

Value of a Bullish Spread Position at Expiration

Bull Spread Using Calls

Long call option

Profit ST K1 K2
Short call option

Max profit difference between strike prices- Net premium paid Maximum loss: limited to net premium paid

Bull spread using calls

Three types of bull spreads can be distinguished: Both calls are initially out of money One call is initially in the money; other call is initially out of the money Both calls are initially in the money

Bull Spreads- An example

An investor buys for $3 a call with a strike price of $30 and sells for $1a call with a strike price of $35. What is the profit from this bull spread strategy a) if the stock price is $25 b) if it is $33 c)If the stock price is $40 Solution:
Stock price $25 $33 $40 Payoff from long call option ($3) $3-$3 =zero $40-30-$3 =$7 Payoff from short Total profit call option $1 $1 $1-($40-$35)=($4) ($2) $1 $3

Bull Spread Using Puts

Max profit: net premium received Maximum loss: difference between strike prices- net premium received Involve a positive upfront cashflow to the investor

Profit K1 K2 ST

Short put option

Long put option

Buy a put at lower strike and sell put with higher strike

Option Spreads
Bearish spreads Using puts buy put with higher strike and sell put with lower strike

Limits both the upside profit potential and downside risk

Involves initial cash outflow
Stock price range Payoff from long Payoff from put option(K2) short put option(K1) ST<=K1 K1<ST<K2 ST>=K2 K2-ST K2 -ST Zero -(K1-ST) Zero Zero Total payoff

K2-K1 K2 -ST Zero

Bear Spread Using Puts

Max profit: Difference between two strike prices- net premium paid Maximum loss: net premium paid

Profit
Short put option

K1

K2

ST

Long put option

Bear spreads using puts An example

An investor buys for $3 a put with a strike price of $35 and sells for $1 a put with a strike price of $30. What is the payoff from the bear spread if a) Stock price is 25 b) Stock price is 33 c) Stock price is 40 Solution: Stock price $25 $33 $40 Payoff from long Payoff from put option short put option $7 $2-$3 =($1) ($3) -$4 $1 $1 Total profits $3 zero ($2)

Bear Spread Using Calls

Max Loss: Difference between two strike prices- net premium paid Maximum profit: Net premium received

Profi t K1 K2

Long call option

ST

Short call option Buy call with higher strike and short call with lower strike Involve an initial cash inflow

Bear Spread Using Calls Payoff

Stock price range ST<=K1 Payoff from long call option(K2) Zero Payoff from short call option(K1) Zero Total payoff

Zero

K1<ST<K2

Zero

-(ST-K1)

-(ST-K1)

ST>=K2

ST- K2

-(ST-K1)

-(K2-K1)

Calendar spreads
The longer the maturity , the more expensive is calendar spread A calendar spread usually requires an initial investment Profit diagrams for calendar spreads show the profits on assumption the long maturity call option is sold on the expiry of the short maturity option. The investor makes profit if the stock price at the expiration of short maturity is close to its strike

Calendar Spread Using Calls

If ST is very high,short maturity option costs investor (ST-K) and long maturity option is worth close to ST-K ,net loss is close to cost of setting up the spread. If ST is close to K, short maturity option costs the investor a small cost and long maturity option is quite valuable

Profit

ST
K

If the stock price is very low on expiry of short maturity option: Short maturity option expire worthless and long maturity option is close to zero

Calendar Spread Using Puts

Profit

ST
K

The resulting payoff is curved. This is because one option is still alive at the expiration date of the other. The maximum possible loss for the neutral calendar spread is limited to the initial debit taken to put on the spread

Example
Assume that Ranbaxy Laboratories stock has two call options with same exercise price of Rs 420 but with a three month option is Rs 25 and six month option is Rs 60 The investor with calendar spread can sell the long maturity at the maturity of the short maturity call and receive the time value of the call option Since the two options do not expire on the same date, it is difficult to directly calculate the profit with a calendar spread.Only a intuitive explanation will help in understanding the profits from calendar spread

Value of a calendar spread at maturity of the short maturity option

Stock price Short call value Long maturity bought call Time value Time value 10+Time value 20+Time value 30+Time value Value of calendar spread Time value Time value Time value Time value Time value 410 420 430 440 450 0 0 -10 -20 -30

Reverse calendar spread

Buying short maturity option and selling long maturity option. A small profit results if the strike price is well above or below the strike price

Hedging for changes in volume

Most of the farmers face uncertainty of the quantity of crop that they would reap at the end of the year Hedging actions aim at protecting falling revenues or rising costs Production and price are inversely related Assume a farmer faces uncertainty about wheat quantity and price.

Possible scenarios
Probability Price of wheat (Rs/kg) 20 30 Quantity(kg) Revenue (Rs)

0.6 0.4

40,000 30,000

8,00,000 9,00,000

Expected price =Rs 24 Farmer would go short in the expected quantity = 36,000 kg His position for two different price scenarios at the end would be as follows:

Price Gain/loss on futures (Rs/kg) (Rs)

20 30 (24-20)*36000 =1,44,0000 (24-30)*36000=-2,16,000

Revenue from crop (Rs)

8,00,000 9,00,000

Total revenue (Rs)

9,44,000 6,84,000

Possible scenarios
Quantity for hedging = Covariance of revenue with price/variance of price
Probability Price of wheat (Rs/kg) 20 30 X =24 Revenue (Rs Variance of in lakh) price Covariance of revenues and price (Rs in lakhs) -0.4*-4*0.6 =.96

0.6 0.4 Total

8 9 8.4

(-4)2 *0.6=9.60

(6)2 *0.4=14.40 0.6*6*0.4= 1.44 24 2.40

Hedging strategy
Quantity for hedging = 2,40,000/24 = 10,000 kg
Price Gain/loss on futures (Rs/kg) (Rs)
20 30 (24-20)*10000 =40,000 (24-30)*10000= -60,000

Revenue from crop (Rs)

8,00,000 9,00,000

Total revenue (Rs)

8,40,000 8,40,000

Calendar spread with Commodity Futures

The spot price of crude oil is Rs.3,000 per barrel. In the futures market 3 months and 6 months contracts are trading Rs.3,125 and Rs.3,200. The cost of carry inclusive of storage and insurance is placed at 15% per annum. If cost of carry model applies find the following. Fair price of futures contracts for 3 months & 6 months. What action can an arbitrageur take in this situation? If at the end of 3 months the spot price were Rs. 3,500 & futures market stood corrected, what would be the profit of the arbitrageur? If at the end of 3 months the spot price were Rs.2,700 and futures market stood corrected, what would be the profit of the arbitrageur?

Solution
A) The fair price of 3 months and 6 months future with cost of carry of 15% and spot value of Rs. 3,000 is: F3= so * ert= 3000* e 0.15*3/12= Rs 3114.64 (actual price= 3125) F6= so * ert= 3000* e 0.15*6/12= Rs 3233.65 (actual price= 3200) An arbitrageur will act as follows:

Solution contd..
3-m future is overvalued and must be sold 6-m future is undervalued and must be bought (bear spread) B) If at the end of 3 months the spot price increased to Rs. 3500 and future prices stand corrected then the fair value of futures would be Rs. 3500 & 3634 at which the investor squares off. The position of investor would be

Solution contd..
Original 3-m futures Sold at 3,125. Bought at 3500. Profit/Loss: (375) Original 6-m futures Bought at 3,200. Sold at 3,634 Profit/loss (+ 434) Net profit on the calendar spread = Rs. 59 C) If at the end of 3 months the spot price decreased to Rs. 2,700 and future price stand corrected, then the fair value of future would be Rs. 2700 & 2803 at which investor squares off. The position of investor would be:

Solution contd..
Original 3-m futures Sold at 3,125 . Bought at 2700 Profit/Loss = +425 Original 6-m futures Bought at 3200. Sold at 2803 Profit/Loss = -397 Net profit on the calendar spread= Rs.28

Review question
Outline your strategies for trading in Rubber in the following cases. Also explain the risks, cost and profit potential in each strategy You expect the market to be extremely bullish given robust demand from end-users You expect the market to be stable at the current level and remain range-bound You expect the market to be extremely volatile from the current levels but are unsure about the direction You expect the market to be extremely volatile only if a range is broken.

Inter Commodity spreads

This strategy involves taking long and short positions in futures contracts in different but correlated commodities. E.g.: if the trader expects the spread between Lead mini & Zinc mini futures to rise the trader can capitalize the price movement by executing the following strategy.

1-Feb-11 Price (per Price (per Contract quintal) Contract quintal) Feb-11(lead 15 Feb-11(lead mini) 120.20 mini) 121.50 Feb-11 (zinc 15 Feb-11 (zinc mini) 111.20 mini) 110.50

15 Feb 2011 (trader's forecast)

Inter Commodity spreads

Step1: the trader buys Feb 2011 Lead mini futures and sells Feb 2011 Zinc mini futures on 1st Feb 2011 Current Spread between Lead Mini & Zinc mini Feb contracts= Price of lead mini Feb 2011 futures- Price of zinc mini 2011 futures Current spread= 120.20-111.20= 9 Traders forecast for prices as on 15th Feb= Price of lead mini Feb 2011 futures- Price of zinc mini 2011 futures.= 121.50-110.50= 11

Profit realized from strategy when spread rises:

Lead mini Zinc mini Buy at sell at 1-Feb-11 120.20 111.20 Sell at buy at 15-Feb-11 121.50 110.50 change

9
11

Profit net profit realised

1.30
2

0.7
2

Intra commodity spread

Consider cumin futures at NCDEX as on 28th September 2005 for October ,November, and December deliveries as 6345,6528,6698 Price differential in November and October =Rs 183 December and November= Rs 170 short on November and Long in December futures