9.3.3-HEDGING AND OTHER OPERATIONS-USING PUT OPTIONS - AN EXAMPLE
Using put options - an example
Instead of selling futures, producers and exporters can establish a minimum price, or price floor, by buying a put option. With a put option in a falling market one can still have a short hedge at a reasonable level. For calculating value, the price floor will be the strike price less the premium paid for the option. The advantage of the option is that if the market goes up the option can simply be allowed to expire, while the physicals can be sold at the higher level (from which the premium paid for the option should of course be deducted to arrive at the net sales realization).
If December futures are trading at 54 cts/lb an exporter or producer might perhaps be able to buy a December 50 cts/lb put for a premium of 2.5 cts/lb. A put is an option to be short, so there is no intrinsic value in being short at 50 cts/lb in a 54 cts/lb market. Furthermore, the right to be short at 50 cts/lb costs 2.5 cts/lb, so the value of the option is really 47.50 cts/lb. In this scenario, the option holder is guaranteed a price floor at 47.50 cts/lb if the market goes down, but they will still be able to take advantage of any upswing in prices if the market rises.
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