Wednesday, May 9, 2012

How do I decide what type of protection?

I was looking today at what gives me the best protection ahead of the USDA crop report.

To answer that question one has to ask more questions; such as how long do I want protection; what type of protection do I need if we move X cents or X dollars up or much do I want to spend.

So after one answers those questions the next thing to do is the what if's; for me I use position book from RJO and run various what if's.

Today I ran the example of if I want to spend $50k in protection using Dec put options what gives me the best bang for my buck.  Do i buy out of the money options?  In the money?  Deep out of the money?  Etc

So I decided to run threw some what if's using Dec corn futures and various strikes.  I believe that I want to have the trigger pulled by July 4th ish; on the cash side; so i ran what if's or theoretically values based on July 6th.

I took 50k and bought as many put options as I could using the following strikes.

5.20 or ATM puts which i figured at 41-42 cents i could buy about 24 of them
5.00 or OTM put which i figured at 31-32 cents i could buy about 32 of them
4.50 or Deep OTM puts which i figured i could buy 77 of them
4.00 or Very Deep OTM (OTM out of the money) which i figured i could buy about 286 of them.

I didn't take into account the more commissions with the more quantity; but here is what i found that gains or losses to be (theoretically based on no volatility changes) at these various futures levels on the Dec Futures

6.00 Dec Futures - all four of the trades are big losers; with the ATM losing the least at 38k loss; followed by the 5.00 puts which lose about 41k, then the 4.50 puts which loss 45k, and lastly the 4.00 puts have lost about all value down about 48k.  Now if we are a producer this is the best option if you don't have 100 % protection because it means we have rallied 80 cents and should have more then paid for the 50k paid in protection

5.00 Dec Futures...give the Higher the strike the more profit. The 5.20 would be up aprox 2500, the 5.00 strikes about 1200, the 4.50 would be losing about 4500 and the 4.00 strikes would have lost you about 14k

4.50 Dec Futures....Here is where you see them all start to make money; this time however the more puts you have the more they make; so the best performance at 4.50 on July 6th ish would be the 4.00 puts which should be up about 75k, followed by the 4.50 puts which should be up about 60k, then followed by the 5.00 up about 48k, and lastly the at the money 5.20 puts are now up only 42k

4.00 Dec Futures....this levels and below is where you really see how well leverage can work for one.....the pattern is the same you are better off having bought more out of the money puts then you are at the money puts even though we are not yet in the money on the 4.00 puts they lead by far; you would now have turned your 50k investment into about 306k profit, your 4.50 would be 176k, your 5.00 would be 111k, and your 5.20 puts would be up about 94k profit

3.50 Dec Futures.....This is where you hit the home run so to speak; turning your 4.00 puts that are worth less then 4 cents when you buy them into about 55 cents each; having bought 286 of them you are now up nearly 750,000 in profits, the others also do good; but not even close versus having the many more 4.00 puts; the 4.50 puts would have about 335k in profit; the 5.00 puts would be up about 111k, and the 5.20 puts up about 94k

Bottom line when deciding what type of coverage you are looking for don't forget to look at the what if's; also keep in mind that the what if's i am looking at are based on 60 days from now; not expiration; as at expiration 4.00 dec futures don't make you any money at 4.00 puts; but in the shorter term they could make you a lot of money

Overall it seems to make sense to buy more OTM if you plan on only holding a short term; they don't perform as well in a sideways market nor an up market; but they are in another league as for performance in a down market

Please give me a call if you have questions

and as always make sure you understand that futures and options are very risky

Here is a screen shot of the what if's that i used in the above example

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