If you are bearish on live cattle, you can profit from a fall in live cattle price by buying (going long) live cattle put options.
You observed that the near-month CME Live Cattle futures contract is trading at the price of USD 0.8445 per pound. A CME Live Cattle put option with the same expiration month and a nearby strike price of USD 0.8400 is being priced at USD 0.0600/lb. Since each underlying CME Live Cattle futures contract represents 40,000 pounds of live cattle, the premium you need to pay to own the put option is USD 2,400.
Assuming that by option expiration day, the price of the underlying live cattle futures has fallen by 15% and is now trading at USD 0.7178 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 live cattle futures at the strike price of USD 0.8400. In other words, it also means that you get to sell 40,000 pounds of live cattle at USD 0.8400/lb on delivery day.
To take profit, you enter an offsetting long futures position in one contract of the underlying live cattle futures at the market price of USD 0.7178 per pound, resulting in a gain of USD 0.1222/lb. Since each CME Live Cattle put option covers 40,000 pounds of live cattle, gain from the long put position is USD 4,888. Deducting the initial premium of USD 2,400 you paid to purchase the put option, your net profit from the long put strategy will come to USD 2,488.
|Long Live Cattle Put Option Strategy|
|Gain from Option Exercise||=||(Option Strike Price - Market Price of Underlying Futures) x Contract Size|
|=||(USD 0.8400/lb - USD 0.7178/lb) x 40000 lb|
|Investment||=||Initial Premium Paid|
|Net Profit||=||Gain from Option Exercise - Investment|
|=||USD 4,888 - USD 2,400|
|Return on Investment||=||104%|
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 live cattle option sale will be equal to it's intrinsic value.
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