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Agricultural Commodity Options Options grants the right, but not the obligation,to buy or sell a futures contract at a predetermined price for a specified period of time.
OPTIONS TERMS Strike Price: The predetermined price of the futures contract i.e. price at which the futures contract can be bought or sold. Premium: The cost of the right to buy or sell a futures contract – cost of the option. The buyer loses the premium regardless of whether the option is used or not.
Real Estate Example Suppose that on June 1, a farmer is approached by his neighbor about purchasing 100 acres of adjacent land at $1,600 per acre. The farmer is almost certain that he wants the land but is unable to arrange financing for six months. The neighbor proposes to grant a six-month option on the property at $1,600 per acre in exchange for a $12 per acre fee ($1,200). This option is similar to a commodity option with the following characteristics: Purchaser = The farmer (Option buyer) Grantor = The neighbor (Option seller) Exercise price = $1,600 (Strike price) Expiration date = December 1 Premium = $1,200
Options are popular because: • Price Insurance. • Limited financial obligation. • Marketing flexibility.
Two Types of Options • PUT OPTION Gives buyer right to sell underlying futures contract. • CALL OPTION Gives buyer right to buy underlying futures contract. • In both cases the underlying commodity is a futures contract, not the physical commodity
PUT OPTION A put option gives the holder the right, but not the obligation, to sell a specific futures contract at a specific price “To put it on them”
Call Option A call option gives the holder the right, but not the obligation, to buy a specific futures contract at a specific price “To call from them”
Put and Call Options • Put Option: • The right to sell a futures contract • Provides protection against falling prices • Sets a minimum price target • Call Option: • The right to buy a futures contract • Protects against rising prices (e.g. feed costs) • Allows participation in seasonal price rises
How Is the Premium ForAn Option Determined? Question: What would you be willing to pay for the right to sell a futures contract at $3.00 if the current futures price is $2.80? Answer: If the premium is under $.20, you could make a profit by exercising the option (sell @ $3) and buy a futures contract for $2.80 at the same time, making a $20 profit.
Factors Affecting Option Premiums • Difference between the strike price of the option and the price of the underlying commodity (futures contract) • INTRINSIC VALUE • Length of time to option expiration • TIME VALUE
Components of Premium • Intrinsic Value + • Time Value = Premium
INTRINSIC VALUE “positive” difference between the strike price and the underlying commodity futures price • FOR A PUT OPTION – strike price exceeds futures price • FOR A CALL OPTION – strike price below futures price
TIME VALUE • Portion of option premium resulting from length of time to expiration. Expiration is the date on which the rights of the option holder expire. • Usually decreases with length of time until expiration, but does increase as price volatility of the underlying futures contract increases.
Components of Time Value • Time • Volatility • Interest rates • Underlying futures price • Strike price
Time value 0.50 0.25 0 180 0 90 Days to expiration Time Decay
Options are said to be:In the money (ITM) – have intrinsic valueOut of the money (OTM) – have no intrinsic value
Call Option In-the-Money (ITM) Strike price < Futures price At-the-Money (ATM) Strike price = Futures price Out-of-the-Money (OTM) Strike price > Futures price
Profit Buy Call @$.50/Bu $1.00 $0.50 Beans Price at Expiration 0 $8.50 $7.50 $8.00 $6.50 $7.00 $0.50 $1.00 OTM ATM ITM Loss Payoff diagram – Long Call Strike Price
Put Option In-the-Money (ITM) Strike price > Futures price At-the-Money (ATM) Strike price = Futures price Out-of-the-Money (OTM) Strike price < Futures price
Profit Buy Put @$.25/Bu $0.50 $0.25 Beans Price at Expiration 0 $8.00 $7.50 $7.75 $7.00 $7.25 $0.25 $0.50 ITM ATM OTM Loss Payoff diagram – Long Put
What Happens to An OptionWhich You Own? • It Can Expire • Unexercised Options Die • You Must Still Pay the Option Premium • You can Exercise the Option • Put: Sell the Futures Contract • Call: Buy the Futures Contract • Offsett, By Selling the Put or Call Option
OPTIONS WORKSHEET STRIKE PRICE ___________ EXPECTED BASIS ___________ PREMIUM ___________ COMMISSION ___________ = EXPECTED MIN NET SELLING PRICE ___________
Put Option Example Date Cash Futures Option Market Market Market Spring Sell Dec. @$4 Buy Dec Put Strike=$4 Premium=$.20 Harvest $2.50 Dec. Fut=$3 Sell Dec Put Sell Dec@$4 Strike=$4 Buy Dec@$3 Premium=$1.20 GAIN……………………..$1………………$1
Pricing Alternatives(Falling Market) Date Cash Sale Forward PreHarvest Option At Harvest Contract Hedge ($.20 prem.) Spring $3.40 Sell Dec Buy Put Planting offer @$4 $4 strike Fall Sell@2.50 Deliver Buy Dec Sell Dec@$4 Harvest @$3.40 @$3 Buy Dec@$3 Net Return $2.50 $3.40 $2.50 cash $2.50 cash +$1 fut.=$3.50 +$1 fut-.20=$3.30
Pricing Alternatives(Rising Market) Date Cash Sale Forward Pre-Harvest Option At Harvest Contract Hedge ($.20 prem.) Spring $3.40 Sell Dec Buy Put Planting offer @$4 $4 strike Fall Sell@4.50 Deliver Buy Dec Let Option Harvest @$3.40 @$5 Lapse/Die Net Return $4.50 $3.40 $4.50 cash $4.50 cash -$1 fut.=$3.50 -.20=$4.30