Pricing Alternatives for Agrium Managers

Allan Gray and Chris Hurt, Purdue University

Pricing Alternatives for Agrium Managers

Agrium Regional Meetings

January/ February 2003

Allan Gray and Chris HurtPurdue University, Indiana


What is an Option?

• Definition: An option is the right, but not the obligation to buy or sell a futures contract at a predetermined price, before expiration.

• Options are derivative instruments. The option is written on an underlying asset -- the futures contract.


Option Terms

Puts (sell) and Calls (buy)

Strike Price (the price at which the buyer has the option)

Premium (the price of option)

Buyer (has option right) Seller (gives the right)

Expiration Date (buyer has right until expiration day)

Futures July Corn = $2.41 ½

Options ---$2.40 July Corn Call= $ .12 6/8

---$2.40 July Corn Put = $ .14 2/8


Puts and Calls

• A put option is the right, but not the obligation, to sell an underlying futures contract at a predetermined price prior to expiration.

• A call option is the right, but not the obligation, to buy the underlying futures contract at a predetermined price prior to expiration.


Strike Price and Premium

• The predetermined price at which an underlying futures contract may be bought or sold is called the strike price or the exercise price.

• The premium is the amount paid for an option. It is the price of the option and is negotiated by open outcry in the trading pit.


Reading Options Premiums

Corn cents/buJuly Futures = 241 ½ Put Call

Strike Price July July

220 4 1/4 25 1/4

230 7 3/4 19 1/2

240 12 3/4 14 1/4

250 18 3/4 10 1/2

Chicago Board of Trade: January 10, 2003


Premiums

• Premiums are determined in an open outcry auction. It’s important to realize that all of the options specifications are set by the exchange except for the premium.

• The premium is paid up-front by the buyer, and must be paid whether the option is exercised or not.


Premiums CompositionOption Premium = Intrinsic Value + Time Value

Intrinsic Value = The immediate positive value if an option were to be exercised

Time Value = The portion of the premium to cover the time until maturity

For the: July Futures = 241 ½ Option Premium = Intrinsic Value + Time Value$2.40 July Corn Call 14 1/4 = 1 ½ + 12 ¾ in

$2.50 July Corn Call 10 ½ = --------- + 10 ½ out

$2.40 July Corn Put 12 ¾ = --------- + 12 ¾ out

$2.50 July Corn Put 18 3/4 = 8 ½ + 10 ¼ in


The Option Strike in Relation to the Underlying Futures Price

• In-the-money: An option is said to be in-the-money if it has positive intrinsic value.

• Out-of-the-money: An option is said to be out-of-the-money if it

has no (or negative) intrinsic value.

• At-the-money: An option is at-the-money if its strike price is

the same as its underlying futures price.


Buyers and Sellers

• Pays premium when purchased plus commission

• Receives all the rights

• Does NOT have to margin position

• Knows the maximum costs at the beginning of the trade but the gain potential is unlimited

• Receives premium when sold, minus commission

• Gives all the rights

• Has to margin position

• Maximum gain is know at the beginning of the trade, but potential loses are unlimited and unknown

Buyer Seller or Writer


Buyers Alternatives

• The buyer of the option may do the following prior to the option expiration:

– Exercise the option and receive the underlying futures,

– Offset the position (Buy a $2.40 July Corn Put is offset

by selling a $2.40 July Corn Put),

– or allow the option to Expire worthless.

• Remember there is No Obligation with an option

purchase!


Sellers Alternatives

• Option Seller (Writer):

– Receives the premium from the option buyer,

– Must take the opposite position if the option is exercised.

As a result,

– The option seller must post margin money,

– and may face margin calls

– Because they take all of the risk of price change.


Your Turn

May 03 SoybeanFutures =

Put CallIn/Out

of-the money

Strike Price May 03 May 03

$5.40

$5.60

$5.80


Similarities of Futures and Options

Futures Options

Legally Binding Yes Yes

Regulated by CFTC Yes Yes

Traded at Exchanges Yes Yes

Broker or cash merchant required

Yes Yes

Expiration date Yes Yes

Can be used to reduce price risk

Yes Yes

Can be used for price speculation

Yes Yes


Differences of Futures and Options

• Obligation to buy or sell• Can take a position

only at current market price

• Must deposit margin money

• No extra premium charge

• Opportunity, but not obligated to buy or sell

• Can take a position at multiple price levels

• Buyers do not deposit margin money

• Buyers pay a premium, sellers receive the premium

Futures Options


Why Options over Futures?• Helps overcome Seller’s or Buyer’s Remorse: Which is

the emotion attached to a person taking a position and then seeing the market move in the opposite direction

– Farmers might says: “As soon as I sell the price moves up,” Or they don’t want to price because they have no further opportunity to gain if prices subsequently rise

• Yield Uncertainty: Crop farmers are hesitant to price before they know their yields

• Posting and Managing Margin: Buyers of options do not post margin while futures position holders must.


6 Pricing Alternatives

Example: Say it’s January 10, 2003 and a producer has 50,000 bushels of corn still in the grain bin and wishes to compare 6 different pricing alternatives for mid-June delivery


The BIG 6 on January 101. Do no pricing, simply wait and see what prices are in

June

2. Forward price now by selling futures

3. Establish a minimum price by buying a put option

4. Consider a second minimum price level by buying another put strike

5. Establish a maximum price by selling a call option

6. Establish both a minimum and a maximum by buying a put and selling a call.


Date of Analysis 1/10/03

Futures ExBasis PutStrike 1 PutPrem 1 CallStrik CallPrem

$2.42 -$0.07 $2.40 $0.13 $2.50 $0.11

CommFutr CommPut CommCall Size(bu.) PutSt2 PutPrem2

$50.00 $50.00 $50.00 5000 $2.20 $0.04

Fence Put Prem Fence Call Prem Comm Interval

$2.30 $0.08 $2.50 $0.11 $100.00 $0.10

Input Form

Strategy# 1 2 3 4 5 6

DoNothing SellFutr BuyPut Buy Put SellCall Fence

2.42 2.40 2.20 2.50 2.30 Buy Put

2.50 Sell Call

Put Premium -0.13 -0.04 -0.08

Call Premium 0.11 0.11

Basis -0.07 -0.07 -0.07 -0.07 -0.07 -0.07

Commission -0.01 -0.01 -0.01 -0.01 -0.02

Adjust to Future -0.07 -0.08 -0.21 -0.12 0.03 -0.06

If Future Move To

$1.82 $1.75 $2.34 $2.19 $2.08 $1.86 $2.24

$1.92 $1.85 $2.34 $2.19 $2.08 $1.96 $2.24

$2.02 $1.95 $2.34 $2.19 $2.08 $2.06 $2.24

$2.12 $2.05 $2.34 $2.19 $2.08 $2.16 $2.24

$2.22 $2.15 $2.34 $2.19 $2.10 $2.26 $2.24

$2.32 $2.25 $2.34 $2.19 $2.20 $2.36 $2.26

$2.42 $2.35 $2.34 $2.22 $2.30 $2.46 $2.36

$2.52 $2.45 $2.34 $2.32 $2.40 $2.54 $2.44

$2.62 $2.55 $2.34 $2.42 $2.50 $2.54 $2.44

$2.72 $2.65 $2.34 $2.52 $2.60 $2.54 $2.44

$2.82 $2.75 $2.34 $2.62 $2.70 $2.54 $2.44

$2.92 $2.85 $2.34 $2.72 $2.80 $2.54 $2.44

$3.02 $2.95 $2.34 $2.82 $2.90 $2.54 $2.44


Basic Pricing Alternatives

$1.50

$1.70

$1.90

$2.10

$2.30

$2.50

$2.70

$2.90

$3.10

$1.82 $1.92 $2.02 $2.12 $2.22 $2.32 $2.42 $2.52 $2.62 $2.72 $2.82 $2.92 $3.02

If Futures Move To

Net

Fin

al P

rice

Rec

eive

d

Cash Only

Sell Futures

Buy Put #3


Basic Pricing Alternatives

$1.50

$1.70

$1.90

$2.10

$2.30

$2.50

$2.70

$2.90

$3.10

$1.82 $1.92 $2.02 $2.12 $2.22 $2.32 $2.42 $2.52 $2.62 $2.72 $2.82 $2.92 $3.02

If Futures Move To

Net

Fin

al P

rice

Rec

eive

d

Cash Only

Sell Futures

Buy Put #4

Sell Call #5


Fence at 1 Strike Above and Below Current Futures

$1.50

$1.70

$1.90

$2.10

$2.30

$2.50

$2.70

$2.90

$3.10

$1.82 $1.92 $2.02 $2.12 $2.22 $2.32 $2.42 $2.52 $2.62 $2.72 $2.82 $2.92 $3.02If Futures Move To

Net

Fin

al P

rice

Rec

eive

d

Cash Only

Sell Futures

Buy Put #4

BuyPut/SellCall #6

Total $ Returns Above Cost

Acres Yield Total Cost

500 150 $162,750 ($2.17 Total Costs)

Strategy # 1 2 3 4 5 6

DoNothing SellFutr BuyPut Buy Put SellCall BullFence

If Futr $2.42 2.40 2.20 2.50 2.30 Buy Put

Move To 2.50 Sell Call

$1.82 -$31,500 $12,750 $1,500 -$6,750 -$23,250 $5,250

$1.92 -$24,000 $12,750 $1,500 -$6,750 -$15,750 $5,250

$2.02 -$16,500 $12,750 $1,500 -$6,750 -$8,250 $5,250

$2.12 -$9,000 $12,750 $1,500 -$6,750 -$750 $5,250

$2.22 -$1,500 $12,750 $1,500 -$5,250 $6,750 $5,250

$2.32 $6,000 $12,750 $1,500 $2,250 $14,250 $6,750

$2.42 $13,500 $12,750 $3,750 $9,750 $21,750 $14,250

$2.52 $21,000 $12,750 $11,250 $17,250 $27,750 $20,250

$2.62 $28,500 $12,750 $18,750 $24,750 $27,750 $20,250

$2.72 $36,000 $12,750 $26,250 $32,250 $27,750 $20,250

$2.82 $43,500 $12,750 $33,750 $39,750 $27,750 $20,250

$2.92 $51,000 $12,750 $41,250 $47,250 $27,750 $20,250

$3.02 $58,500 $12,750 $48,750 $54,750 $27,750 $20,250


Which Pricing Alternative to Choose:

Depends Upon

1. Outlook for Prices

2. Costs of Production

3. Risk Bearing Ability

4. Understanding and

Comfort with various

Pricing Alternatives


Agrium Marketing Software

• The 6 Price Analysis Program is located at:

• http://www.agecon.purdue.edu/staff/gray/agrium/agrium.htm

Pricing Alternatives for Agrium Managers

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