Futures price falls by $1/bu. to $6.80 by late August: If the futures price is $6.80 a month from now, the premium on each put option contract would increase to $1.15, a gain of 53¢/bu. Since two put options were purchased for the hedge, the total gain on the option position is 2 x 53¢ = $1.06/bu. This amount slightly more than offsets the $1 decline in the futures price used to determine the RP payout, so the farmer is 6¢/bu. better off than he would have been from using a futures hedge.

At this point, the hedger could lift the hedge by selling the two put options to capture the $1.06 per bushel in premium. If the futures price is still $6.80 in October, the hedging gain would be $148.40/acre (140 bu. x $1.06/bu.) and total revenue, borrowing from the July 24 farmdoc Daily post, would be $1,090.40/acre ($670 crop revenue + $272 RP payment + $148.40 hedging gain), or $8.40/acre more than with the futures hedge. Alternatively, the farmer could hold the options until October and maintain the hedge against further declines. However, if prices do not continue to decline, maintaining the hedge will incur additional costs, as shown in the next example.

 

Futures price falls by $1/bu. to $6.80 by late October:If the futures price is $6.80 at the end of the October, the premium on each put option contract would be $1.02, a gain of 40¢/bu. on each option. Since two put options were purchased for the hedge, the total gain on the option position is 2 x 40¢ = 80¢/bu. Notice that this amount is 20¢/bu. less than the $1 decline in the futures price used to determine the RP payout, so the option hedge failed to cover the entire change in the insurance payment caused by falling prices, and the farmer is 20¢/bu. worse off than he would have been from using a futures hedge.

On a per-acre basis, the hedging gain would be $112/acre (140 bu. x 80¢/bu.) and the total revenue would be $1,054/acre ($670 crop revenue + $272 RP payment + $112 hedging gain), or $28/acre less than with the futures hedge. The difference of 26¢/bu. ($1.06 – 0.80) or $36.40/acre ($1,054 – 1,090.40) between late August and late October is due entirely to the erosion in the time value component of the option premium. Time value erosion can greatly affect the performance of option hedges, particularly when the options are held for extended periods with little or no price movement. Option hedges provide best results with large, unfavorable price changes that occur over relatively short periods of time.