ECON 337: Agricultural Marketing

1. ECON 337: Agricultural Marketing Lee Schulz Assistant Professor lschulz@iastate.edu 515-294-3356 Chad Hart Associate Professor chart@iastate.edu 515-294-9911

2. Options • What are options? • An option is the right, but not the obligation, to buy or sell an item at a predetermined price within a specific time period. • Options on futures are the right to buy or sell a specific futures contract. • Option buyers pay a price (premium) for the rights contained in the option.

3. Option Types • Two types of options: Puts and Calls • A put option contains the right to sell a futures contract. • A call option contains the right to buy a futures contract. • Puts and calls are not opposite positions in the same market. They do not offset each other. They are different markets.

4. Put Option • The Buyer pays the premium and has the right,but not theobligation,to sell a futures contract at the strike price. • The Seller receives the premium and isobligatedtobuy a futures contract at the strike price if the Buyer uses their right.

5. Call Option • The Buyer pays a premium and has the right, but not theobligation,to buy a futures contract at the strike price. • The Seller receives the premium butis obligatedtosell a futures contract at the strike price if the Buyer uses their right.

6. Options as Price Insurance • The person wanting price protection (the buyer) pays the option premium. • If damage occurs (price moves in the wrong direction), the buyer is reimbursed for damages. • The seller keeps the premium, but must pay for damages.

7. Options as Price Insurance • The option buyer has unlimited upside and limited downside risk. • If prices moves in their favor, the option buyer can take full advantage. • If prices moves against them, the option seller compensates them. • The option seller has limited upside and unlimited downside risk. • The seller gets the option premium.

8. Option Issues and Choices • The option may or may not have value at the end • The right to buy corn futures at $6.00 per bushel has no value if the market is below $6.00. • The buyer can choose to offset, exercise, or let the option expire. • The seller can only offset the option or wait for the buyer to choose.

9. Strike Prices • The predetermined prices for the trade of the futures in the options • They set the level of price insurance • Range of strike prices determined by the futures exchange

10. Options Premiums • Determined by trading in the marketplace • Different premiums • For puts and calls • For each contract month • For each strike price • Depends on five variables • Strike price • Price of underlying futures contract • Volatility of underlying futures • Time to maturity • Interest rate

11. Option References • In-the-money • If the option expired today, it would have value • Put: futures price below strike price • Call: futures price above strike price • At-the-money • Options with strike prices nearest the futures price • Out-of-the-money • If the option expired today, it would have no value • Put: futures price above strike price • Call: futures price below strike price

12. Options Premiums Dec. 2014 Corn Futures $4.60 per bu. In-the-money Out-of-the-money Source: CME, 2/5/13

13. Setting a Floor Price • Short hedger • Buy put option • Floor Price = Strike Price + Basis – Premium – Commission • At maturity • If futures < strike, then Net Price = Floor Price • If futures > strike, then Net Price = Cash – Premium – Commission

14. Put Option Graph Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $4.60 Put Option Return = Max(0, Strike Price – Futures Price) – Premium – Commission Premium = $0.36125 Commission = $0.01

15. Put Option Graph Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $4.60 Premium = $0.36125 Net = Cash Price + Put Option Return

16. Short Hedge Graph Sold Dec. 2014 Corn Futures @ $4.5925 Net = Cash Price + Futures Return

17. Short Hedge Graph Sold Dec. 2014 Corn Futures @ $4.5925 Net = Cash Price + Futures Return

18. Comparison

19. Out-of-the-Money Put Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $3.00 Premium = $0.005

20. In-the-Money Put Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $6.00 Premium = $1.45

21. Comparison

22. Setting a Ceiling Price • Long hedger • Buy call option • Ceiling Price = Strike Price + Basis + Premium + Commission • At maturity • If futures < strike, then Net Price = Cash + Premium + Commission • If futures > strike, then Net Price = Ceiling Price

23. Call Option Graph Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $4.60 Call Option Return = Max(0, Futures Price – Strike Price) – Premium – Commission Premium = $0.35375 Commission = $0.01

24. Call Option Graph Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $4.60 Net = Cash Price – Call Option Return

25. Long Hedge Graph Bought Dec. 2014 Corn Futures @ $4.5925 Net = Cash Price – Futures Return

26. Comparison

27. Summary on Options • Buyer • Pays premium, has limited risk and unlimited potential • Seller • Receives premium, has limited potential and unlimited risk • Buying puts • Establish minimum prices • Buying calls • Establish maximum prices

28. Class web site: http://www.econ.iastate.edu/~chart/Classes/econ337/Spring2014/ Have a great weekend!