If you are bearish on feeder cattle, you can profit from a fall in feeder cattle price by buying (going long) feeder cattle put options.
You observed that the near-month CME Feeder Cattle futures contract is trading at the price of USD 0.9520 per pound. A CME Feeder Cattle put option with the same expiration month and a nearby strike price of USD 0.9500 is being priced at USD 0.0600/lb. Since each underlying CME Feeder Cattle futures contract represents 50,000 pounds of feeder cattle, the premium you need to pay to own the put option is USD 3,000.
Assuming that by option expiration day, the price of the underlying feeder cattle futures has fallen by 15% and is now trading at USD 0.8092 per pound. At this price, your put option is now in the money.
By exercising your put option now, you get to assume a short position in the underlying feeder cattle futures at the strike price of USD 0.9500. In other words, it also means that you get to sell 50,000 pounds of feeder cattle at USD 0.9500/lb on delivery day.
To take profit, you enter an offsetting long futures position in one contract of the underlying feeder cattle futures at the market price of USD 0.8092 per pound, resulting in a gain of USD 0.1408/lb. Since each CME Feeder Cattle put option covers 50,000 pounds of feeder cattle, gain from the long put position is USD 7,040. Deducting the initial premium of USD 3,000 you paid to purchase the put option, your net profit from the long put strategy will come to USD 4,040.
|Long Feeder Cattle Put Option Strategy|
|Gain from Option Exercise||=||(Option Strike Price - Market Price of Underlying Futures) x Contract Size|
|=||(USD 0.9500/lb - USD 0.8092/lb) x 50000 lb|
|Investment||=||Initial Premium Paid|
|Net Profit||=||Gain from Option Exercise - Investment|
|=||USD 7,040 - USD 3,000|
|Return on Investment||=||135%|
In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.
In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the feeder cattle option sale will be equal to it's intrinsic value.
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