The accuracy of the regression equation is indicated by the close relationship between the call option prices and the predicted option prices. The next step uses the regression equation developed for September 2010 copper call options to compute predicted prices for hypothetical call options on three-month LME steel futures on July 1, 2010.
On July 1, the steel futures price was $430 per tonne on a 65-tonne contract. The call prices calculated are charted in “Call options on steel futures” (below). Intrinsic values for each strike price equal the futures price less the strike price and delta is equal to the slope of the option price curve at each strike -- the expected change in the option price for each dollar of change in the underlying futures price.
Upper and lower breakeven prices for copper and steel futures reflect the potential range of the underlying at expiration in approximately three months. While the price range for copper options is tied to actual market prices for the calls on July 1, steel futures have no published option prices and the predicted call prices, as well as breakeven prices depend (as shown in the previous calculations), on similar volatilities of steel futures and copper futures.
In both sets of calculations, the breakeven prices are prices at expiration that will result in zero profit or loss for a delta trade -- selling call options against long futures contracts in a ratio that is the inverse of delta.
One advantage of the option pricing method shown here is that the same technique may be used with any pair of futures for which the underlying price volatilities approach equality. In the present case -- that of steel futures -- call and put options may arise in the near future in addition to the present over-the-counter market in swaps on iron ore and steel. Preparation for potential trades may include simulating options on steel futures based on other related metal options.
Traders in equities of steel producers gain from the expanding market for steel futures because both futures prices and the companies’ expected earnings are affected by the same underlying forces of consumer demand and raw material pricing.
Commodity price and share price relationships are illustrated on “Taking stock of steel” (below). Movements of the U.S. Steel stock price are closer to steel futures prices than those of Nucor. The reasons include differences in product markets between Nucor and U.S. Steel. For investors in steel equities, the futures market provides additional information on current and future earnings and valuation.
Over the next few years, we may observe the growth of this relatively new futures market and learn to take advantage of the opportunities it presents for trading and hedging for buyers and sellers of steel products.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
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