Understanding Agricultural Options

Understanding Agricultural Options

John HobertJohn Hobert

Farm Business Management ProgramRiverland Community College

Why are Agricultural Options Popular?Why are Agricultural Options Popular? Options are basically easy to understand Options are basically easy to understand

as compared to the Futures Hedge.as compared to the Futures Hedge. An options hedger is protected against An options hedger is protected against

any “unfavorable price change.”any “unfavorable price change.” A hedger does not have to deposit any A hedger does not have to deposit any

margin money or worry about margin margin money or worry about margin calls.calls.

Why are Agricultural Options Popular?Why are Agricultural Options Popular? Options allow buyers of agricultural Options allow buyers of agricultural

products to set “ceiling” prices to protect products to set “ceiling” prices to protect against price increases.against price increases.

Options allow the opportunity to gain Options allow the opportunity to gain from rising markets. (puts)from rising markets. (puts)

Options allow the opportunity to gain Options allow the opportunity to gain from price decreases in the market. from price decreases in the market. (calls)(calls)

Why are Agricultural Options Popular?Why are Agricultural Options Popular? Options permit producers to establish Options permit producers to establish

“floor” prices for protection against “floor” prices for protection against falling markets.falling markets.

What is an Option?What is an Option?

An Option is simply the right, but An Option is simply the right, but not the obligation, to buy or sell a not the obligation, to buy or sell a futures contract at some futures contract at some predetermined price at anytime predetermined price at anytime within a specified time period.within a specified time period.

Option terminology:Option terminology:

An option to buy a futures contract is An option to buy a futures contract is known as a “call option.”known as a “call option.”

An option to sell a futures contract is An option to sell a futures contract is known as a “put option.”known as a “put option.”

The predetermined futures price at which The predetermined futures price at which the future contract may be bought or sold the future contract may be bought or sold is called the “strike or exercise price,” is called the “strike or exercise price,” strike price being most commonly used.strike price being most commonly used.

More Option Terminology:More Option Terminology:

The “premium” is the amount paid for The “premium” is the amount paid for an option.an option.

The individual purchasing an options The individual purchasing an options contract is referred to as the “options contract is referred to as the “options buyer” or “holder.”buyer” or “holder.”

An options contract is said to be “in the An options contract is said to be “in the money” when it has intrinsic value.money” when it has intrinsic value.

Intrinsic values in a nut shell:Intrinsic values in a nut shell:

An option has an intrinsic value if it An option has an intrinsic value if it would be profitable to exercise the would be profitable to exercise the option.option. Call Options have intrinsic value when the Call Options have intrinsic value when the

strike price is below the futures price.strike price is below the futures price. Put Options have intrinsic value when the strike Put Options have intrinsic value when the strike

price is above the futures price.price is above the futures price.

“In the Money” Examples:“In the Money” Examples:

Call Option Example: (Long Position)Call Option Example: (Long Position) Dec corn futures price is $2.50/Bu.Dec corn futures price is $2.50/Bu. Dec corn call has a “strike price” of $2.20/Bu.Dec corn call has a “strike price” of $2.20/Bu. The contract’s “intrinsic” value is $ .30/Bu.The contract’s “intrinsic” value is $ .30/Bu.

Put Option Example: (Short Position)Put Option Example: (Short Position) July corn futures price is $2.50/Bu.July corn futures price is $2.50/Bu. July corn put has a “strike price” of $2.70/Bu.July corn put has a “strike price” of $2.70/Bu. The contract’s “intrinsic” value is $ .20/Bu.The contract’s “intrinsic” value is $ .20/Bu.

More Option Terminology:More Option Terminology:

An options contract is said to be “out of An options contract is said to be “out of the money” when it has no intrinsic the money” when it has no intrinsic value.value.

An options contract is said to be “at the An options contract is said to be “at the money” when the strike price is equal to money” when the strike price is equal to the current market price.the current market price.

The “time value” is equal to the premium The “time value” is equal to the premium less the intrinsic value of the contract.less the intrinsic value of the contract.

“Out of the Money” Examples:“Out of the Money” Examples:

Call Option Example: (Long Position)Call Option Example: (Long Position) Dec corn futures price is $2.20/Bu.Dec corn futures price is $2.20/Bu. Dec corn call has a “strike price” of $2.50/Bu.Dec corn call has a “strike price” of $2.50/Bu. The contract has no “intrinsic value.”The contract has no “intrinsic value.”

Put Option Example: (Short Position)Put Option Example: (Short Position) Jul. corn futures price is $2.70/Bu.Jul. corn futures price is $2.70/Bu. Jul. corn put has a “strike price” of $2.50/Bu.Jul. corn put has a “strike price” of $2.50/Bu. The contract has no “intrinsic value.”The contract has no “intrinsic value.”

“At the Money” Examples:“At the Money” Examples:

Call Option Example: (Long Position)Call Option Example: (Long Position) Dec corn futures price is $2.50/Bu.Dec corn futures price is $2.50/Bu. Dec corn call has a “strike price” of $2.50/Bu.Dec corn call has a “strike price” of $2.50/Bu. The contract has no “intrinsic value.”The contract has no “intrinsic value.”

Put Option Example: (Short Position)Put Option Example: (Short Position) Jul. corn futures price is $2.70/Bu.Jul. corn futures price is $2.70/Bu. Jul. corn put has a “strike price” of $2.70/Bu.Jul. corn put has a “strike price” of $2.70/Bu. The contract has no “intrinsic value.”The contract has no “intrinsic value.”

Options Practice Problem:Options Practice Problem:

Assume you pay a premium of $ .30/Bu. for Assume you pay a premium of $ .30/Bu. for a call with a strike price of $7.00 and that a call with a strike price of $7.00 and that the futures price at expiration is $7.50.the futures price at expiration is $7.50. What is the intrinsic value?What is the intrinsic value? Is the call in the money, out of the money, or at Is the call in the money, out of the money, or at

the money?the money? What is the most you can lose on this contract?What is the most you can lose on this contract? What are my margin requirements?What are my margin requirements?

Options Practice Problem 2:Options Practice Problem 2:

Assume that May November futures for Assume that May November futures for soybeans are at $8.30/Bu. while the May soybeans are at $8.30/Bu. while the May November call option strike price is at November call option strike price is at $8.50 at a cost of a $ .12 premium.$8.50 at a cost of a $ .12 premium. What is the intrinsic value of the contract?What is the intrinsic value of the contract? What is the time value of the contract?What is the time value of the contract? Why does the contract have time value?Why does the contract have time value? What do you hope occurs?What do you hope occurs?

What are my alternatives at the end an Options contract?What are my alternatives at the end an Options contract? The option buyer obtains the right to

exercise his chosen alternative by paying the premium to an option seller.

Exercise his option. (put) or (call) Sell the option to someone else. Let the option expire.

Option Basics:Option Basics:

Premiums depend on market conditions Premiums depend on market conditions such as volatility, time until an option such as volatility, time until an option expires, and economic variables.expires, and economic variables.

The premium of an option is discovered The premium of an option is discovered through public out-cry in the CBOT pits.through public out-cry in the CBOT pits.

Trading months for options are the same as Trading months for options are the same as those of the underlying futures contracts those of the underlying futures contracts discussed in our futures unit of instruction.discussed in our futures unit of instruction.

More Option Basics:More Option Basics:

As futures prices increase or decrease, As futures prices increase or decrease, additional higher and lower strike prices are additional higher and lower strike prices are listed.listed.

Option strike prices can be found in daily Option strike prices can be found in daily newspapers, through on-line quotation newspapers, through on-line quotation services (DTN), internet, local grain services (DTN), internet, local grain elevators or brokers.elevators or brokers.

Commission fees are charged by brokers.Commission fees are charged by brokers.

Strike Price Basics:Strike Price Basics:

Strike prices are listed in predetermined Strike prices are listed in predetermined multiples for each commodity:multiples for each commodity: $ .25 per bushel for soybeans$ .25 per bushel for soybeans $ .10 per bushel for corn$ .10 per bushel for corn $ .10 per bushel for wheat$ .10 per bushel for wheat $ .10 per bushel for oats$ .10 per bushel for oats $5.00 per ton for SBOM below $200/ton$5.00 per ton for SBOM below $200/ton $10.00 per ton for SBOM above $200/ton$10.00 per ton for SBOM above $200/ton

Strike Price Basics Continued:Strike Price Basics Continued:

The listed strike prices will include an at-The listed strike prices will include an at-or near-the-money option, at least five or near-the-money option, at least five strikes below and at least nine strikes strikes below and at least nine strikes above the at-the-money options.above the at-the-money options.

This applies to both puts and calls.This applies to both puts and calls. The five lower strikes would follow The five lower strikes would follow

normal commodity intervals.normal commodity intervals.

Strike Price Basics Continued:Strike Price Basics Continued:

The nine higher strikes would include The nine higher strikes would include five at normal intervals above the at-the-five at normal intervals above the at-the-moneys, plus an additional four strikes moneys, plus an additional four strikes listed in even strikes that are double the listed in even strikes that are double the normal intervals discussed previously.normal intervals discussed previously.

Five Strategies for Buying and Selling Agricultural Options:Five Strategies for Buying and Selling Agricultural Options: Buying put options for protection against Buying put options for protection against

lower prices. lower prices. Buying put options for “price insurance” Buying put options for “price insurance”

when you store your crop.when you store your crop. Writing call options to achieve a higher Writing call options to achieve a higher

effective selling price for a crop you are effective selling price for a crop you are storing.storing.

Five Strategies for Buying and Selling Agricultural Options:Five Strategies for Buying and Selling Agricultural Options: Buying call options at harvest to profit from Buying call options at harvest to profit from

a winter/spring price increase.a winter/spring price increase. Buying call options for short-term Buying call options for short-term

protection against rising prices.protection against rising prices.

Options offer “versatility:”Options offer “versatility:”

They can be used for protection against They can be used for protection against declining prices or against rising prices.declining prices or against rising prices.

They can be used to achieve short-term They can be used to achieve short-term objectives or long-term objectives.objectives or long-term objectives.

They can be used conservatively or They can be used conservatively or aggressively.aggressively.

You hold the right to exercise your option You hold the right to exercise your option when you feel it is the right time.when you feel it is the right time.

Take Home Review Test:Take Home Review Test:

Free Breakfast at the June Meeting for Free Breakfast at the June Meeting for the individual scoring the highest on the the individual scoring the highest on the review test courtesy of JCH.review test courtesy of JCH.

In case of tie, we will draw for the In case of tie, we will draw for the winner.winner.

This format will be continued in the This format will be continued in the future to encourage you to review each future to encourage you to review each meeting for your benefit.meeting for your benefit.

Next Month:Next Month:

Strategy Examples for Strategy Examples for Buying and Selling Buying and Selling Agricultural Options.Agricultural Options.