Put Options Lesson 2: Hedge Your Crops With No Margin Calls

Written 22 April 2022

In lesson 1, I wrote about clients who bought September wheat puts with September wheat futures right at $11.00. People were paying 60¢ per bushel for the right to sell September wheat futures at $10.00 and 20¢ for the right to sell September wheat at $9.00.

Why would anybody pay so much money for the right to sell September wheat $1 and $2 below the current price?

Why not just sell the September wheat futures at $11.00 and not spend $2,943.75 for the right to sell September wheat at $10? It’s a no brainer, right? Well, yes and no.

Currently, one has to have $4,510 in their futures account to sell (or buy) one 5,000 bushel wheat futures contract. That is $1566.25 more money tied-up than to buy the $10 put; i.e. less cash is tied up to buy the $10 put than to sell futures at any price.

If September wheat moves higher, the put option declines in value, but the buyer already paid full price for the put, so no one will require the buyer of the put to cover the loss.

With the futures position, the initial margin deposit of $4,510 is really a down payment on $55,000 worth of wheat (5,000 bushels times $11.00). If wheat goes up 1 cent, that $55, 000 worth of wheat’s value increases to $55,050 (1 cent times 5,000 bushels = $50). In which case the buyer of wheat futures at $11.00 now has $50 added to his account. Guess where that $50 comes from? From the trader’s account that sold September wheat at $11.00; in this example that would be your hedge account! In that case, you have lost $50 in the futures market.

What happens to the premium of the $10 put if wheat futures price goes up 1¢? Well, of course, it lost value, but only 31 hundredths of a cent. How do we know that? Because the delta of the $10 September wheat put on April 14th was 0.31.

The chart below is the same we showed in Lesson 1, namely the September option settlement prices for April 14th, the day before Good Friday. The delta column at the $10 strike price says 0.31 (=31%). The delta of an option is the percentage of the price change of the option for a change in the price of the underlying futures contract. Had September futures price lost one cent, likewise, the value of the put option would have increased only 31 hundredths of a cent.

Why would the option premium increase if futures lost one cent? Think about it! This is not rocket science! The buyer of the put buys the right to sell futures at the strike price. As the futures price declines, the strike price never changes, but more people are willing to pay-up for every put option. Puts increase in value as futures

price decline.

The reason the $10 put option premium changes about one-third the rate of the futures is because the $10 put option is a dollar out-of-the-money; meaning, if that put was exercised (exchanged for a futures contract), the resulting futures position would be losing $1.00; the futures short (sold) position would be $10 (the option’s

strike price) with the futures price was at $11.01 on the close.

Right now, September wheat futures price is up 16¼ cents. Thus, the traders who sold September wheat futures have lost $812.50.

About how much did the owner of a $10 put lose so far today? $251.87 (delta of .31 times 16¼ cents times 5,000 bushels per contract).

About how much did the owner of $9 put lose so far? $154.37 (delta of .19 times 16¼ cents on 5,000 bu. contract).

If wheat goes to $25 this year like spring wheat did 2008, would you rather own a put option or be short (sold) wheat futures?