Futures vs Option on Futures

[ExamTortoise]

Why use a Future to hedge instead of an option on a Future.

For example, why would a corn farmer hedge the price of his crop by shorting a Future instead of buying a Futures Put option.

Both ways he is protected if the price of corn drops but with the Future Put option he maintains his upside if the price of corn increases.

The only thing I can think of is he pays a "premium" for a put which he doesn't on a Future.

[Gareth]

Because he doesn't need the option. He will be selling his crop whatever happens, hence the future provides a perfect hedge.

The option part of your suggested hedge would be wasting his money.

[ExamTortoise]

Gareth, what is wrong with this reasoning?

Price of corn goes down, exercise the Future put option and get the cash that you are currently in-the-money as well as a short Futures option to sell your corn at the Future price.

Price of corn goes up, let put option go unexercised and sell your corn in the market for more than the Futures price.

Seems like you can't be worse off but can be better off with the Futures Put option.

I mean if you own a stock and know you will sell it in a month, you can buy a put with an exercise price equal to the current stock price x one month's risk-free interest to protect you against a loss but still keep the potential for a gain open. Or you can short a stock future and eliminate any chance for a gain or loss and just deliver the stock in a month.

[Gareth]

Well before worrying about the maths, he's a farmer. He just about understands the future contract, all this stuff about options is giving him a headache.

The future provides him a premium-less guarantee he can sell his corn at the current price, which means he has security and can budget his costs.

I'll come back to the maths a bit later after some food :-)

[WWSituation]

Futures are 1-dimensional (slope) contracts, while options are 2-dimensional (slope & curvature).

Basic hedging in commodities requires only 1-dimension as their exposure does not have convexity.

[ExamTortoise]

how does that apply to the Farmer? In other words, I still ask "what is the flaw in my reasoning?"

[KindGrind]

well, let's take a little example about corn price:

Let's suppose that the spot price is 500 per bushnel
The 6-month future price is selling at 550.
The option for the short position in the future contract sells at 25 with a strike price of 550.

If you directly buy the future contract, you're sure to lock the price to 550 in 6 months. If you buy the put option, you're also sure of locking the price to 550, but it costs you 25 to take that position, the net price per bushnel sold is 525. The difference is also that you can possibly make a greater profit if the price gets higher than 575.

If the real spot price in 6 months is lower than 575, you'll be better off with the future contract alone. If the real spot price in 6 months is greater than 575, you'll be better off with the future contract alone.

In a world where no arbitrage opportunities exist, the price of the option would equal the potential profit loss from the future contract.

I'm not sure I've been clear, but anyway, I tried! :)

[ExamTortoise]

You will note that in the orginal post I mentioned "The only thing I can think of is he pays a "premium" for a put which he doesn't on a Future." which I believe is the gist of your reply.

Again, thanks.

[Cracktuary]

Both ways he is protected if the price of corn drops but with the Future Put option he maintains his upside if the price of corn increases.

The only thing I can think of is he pays a "premium" for a put which he doesn't on a Future.

Like you said, he pays a premium for the upside. If you're looking for a perfect hedge to lock in price = X, then enter into a futures contract.

If you want to lock in (net) price = X - p, but retain the right to sell your corn when price > X, then buy a put option.

[Scooterpye]

The only thing I can think of is he pays a "premium" for a put which he doesn't on a Future.

You answered your own question. If the put were free, the farmer would always buy that for nothing and would never sell any futures.