Trading and Hedging with Agricultural Futures and Options

James B. Bittman

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9781592803293
• eBook ISBN: 9781118538760
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Today's Premier Guidebook for Understanding Agricultural Options and Making Them a Key Part of Your Trading and Risk Management Strategy Agricultural futures and options represent a vital niche in today's options trading world. Trading and Hedging with Agricultural Futures and Options takes an in-depth look at these valuable trading tools, and presents clear, proven strategies and techniques for both hedgers and traders to achieve their goals while minimizing risk.

Relying on nuts-and-bolts techniques and examples as opposed to the mathematical models and theory favored by other options-trading manuals this practical, hands-on book discusses many topics, including:

• How hedgers and traders can use options effectively with realistic expectations
• Methods to understand price behavior including the "Greeks" (delta, gamma, vega, and theta)
• The importance of volatility and little-known ways to make it work to your advantage

For producers and processors, agricultural futures and options are necessary components for controlling costs and hedging risks. For traders, they are proven vehicles for earning exceptional risk-adjusted profits. Whichever side of the aisle you are on, Trading and Hedging with Agricultural Futures and Options will provide you with the answers you need to effectively use these versatile tools and make them an integral part of your business.

Part 1

The Basics of Futures and Options

Chapter One

The Terminology of Futures and Options

This chapter defines the terminology that hedgers and traders need to know. As experienced traders will see, however, not every term associated with futures and options is covered. Frankly speaking, one of the reasons why futures and options are frequently considered more complicated than they actually are is that technical words are used incorrectly or with conflicting meanings. There are, in fact, many technical terms that most hedgers and traders do not need to know. The following list of terms will be used throughout this book as defined in this chapter:

Futures contract	American-style exercise
Call option	European-style exercise
Put option	Effective purchase price
Long futures	Effective selling price
Short futures	Option buyer
Long call	Option writer
Short call	In-the-money, at-the-money,
Long put	out-of-the-money
Short put	Premium
Strike price (exercise price)	Intrinsic value
Delivery date	Time value
Expiration date	Initial margin
Exercise (and exercise notice)	Maintenance margin
Assignment (and notice of assignment)	Margin call Mark to the market

If you are familiar with these terms, you may skip ahead to Chapter 2. If you wish to read through the following definitions, keep in mind that they are written on a basic level. The nuances will be explained in later chapters.

This chapter will first discuss futures contracts, then call options, and then put options. At the end of the chapter some questions (with the answers following) will help reinforce your understanding.

FUTURES CONTRACTS

The Delivery Date

A futures contract is an agreement between two parties, a buyer and a seller, to exchange a standardized good, the commodity, for an agreed-upon price at a specific date in the future, the delivery date. The agreement is made through representatives of the parties, commodities brokers, on the floor of an organized futures exchange. The exchange guarantees the performance of both parties. The specifications and delivery procedures of the standardized good are detailed in the futures contract. Unless a futures contract is closed out before the delivery date, both the buyer and the seller are obligated to fulfill their sides of the transaction.

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Buyers of futures are obligated to buy

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It is the standardized nature of a futures contract and the exchange guarantee that distinguish a futures contract from a forward contract, which is a unique negotiated agreement between two parties. An example of a forward contract occurs when Party A agrees to buy 12,600 bushels of soybeans from Party B on October 9. The advantage of a negotiated forward contract is that the buyer gets exactly what is needed when it is needed. The seller of a forward contract gets a desired price and a desired delivery schedule. One disadvantage of a forward contract is that both parties assume performance risk. In this example, Party A assumes the risk that Party B will deliver soybeans of the specified grade on the specified date, and Party B assumes the risk that Party A will accept delivery and pay. Another disadvantage of forward contracts is that neither party can get out of the contract, even at a loss, without the permission of the other party. If Party A wants to cancel the contract but Party B refuses, Party A must find a third party, acceptable to Party B, to buy exactly 12,600 bushels of the specific grade of soybeans on October 9. This is known as an “illiquid” contract.

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Sellers of futures are obligated to sell

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Futures contracts, however, have the advantage of being very liquid. Unless extraordinary market conditions exist in which a futures contract has reached its upper or lower price limit for a particular trading session, futures contracts can be traded freely. Also, futures contracts involve neither performance risk nor the expenses of negotiation. Futures contracts are generally far less costly to administer than are forward contracts.

Standardization is the major disadvantage of futures contracts. If a contract covers 5,000 bushels, for example, it is impossible to get 12,600 bushels delivered through the exchange’ delivery mechanism. A buyer must purchase either two or three contracts in that case. Nevertheless, the growth of futures markets indicates that many market participants find that the advantages outweigh the disadvantages.

Margin Accounts and Margin Deposits

After entering into a futures contract, both the buyer and the seller must deposit funds in an account with the broker to demonstrate that they are financially capable of fulfilling the terms of the contract. The deposit is known as a margin deposit and the account is known as the margin account. The actual risk borne by the parties is usually substantially larger than the margin deposit. Users of futures and options need to be aware of margin account procedures because different strategies have different margin requirements.

Initial Margin, Maintenance Margin, and Margin Call

Initial margin is the minimum account equity required to establish a position. Initial margin requirements for futures and futures options frequently are expressed in absolute dollar terms. The initial margin for a soybean futures position, long or short, for example, might be $900. If a position loses money, the account equity, i.e., the margin, will decrease. Minimum margin is the level, expressed as an absolute dollar amount, at or above which the account equity must be maintained. If account equity falls below the minimum margin level, the brokerage firm will notify the trader in a margin call that the account equity must be raised to the maintenance level. Maintenance margin is the level of account equity to which an account balance must be raised when a margin call is received. Maintenance margin is typically less than initial margin. Upon receiving a margin call, a trader may either deposit additional funds or securities or close the position.

Mark to the Market

A process that ensures that buyers and sellers of futures contracts are in compliance with the minimum margin requirements established by the exchange is known as marking to the market. By this process, the margin account balances of both the buyer and the seller are adjusted daily to reflect changes in the price of the futures contract.

Assume, for example, that on day 1 John buys one wheat futures contract from Ramona. Assume also that this contract covers 5,000 bushels of wheat, the price is $3.00 per bushel, and the margin requirement is $1,000. This means that both John and Ramona must deposit $1,000 in accounts with their brokers.

Now consider the risks that John and Ramona are assuming. John has agreed to buy 5,000 bushels at $3.00 each for a total commitment of $15,000. In theory, if the price of wheat were to drop to zero, John would be obligated to pay $14,000 in addition to the $1,000 already in his account, and his total loss would be $15,000.

Ramona’s risk is different. If Ramona has 5,000 bushels of wheat ready to deliver, she has no risk other than opportunity risk, the risk that the pric...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Foreword
• Acknowledgments
• Disclosures
• Introduction
• Part 1: The Basics of Futures and Options
• Part 2: Hedging Strategies
• Part 3: Trading Strategies
• Index
• About the Author