Agricultural Commodity Options

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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 specifiedperiod of time.

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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.

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Real Estate ExampleSuppose 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

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Options are popular because:

1) Price Insurance.

2) Limited financial obligation.

3) Marketing flexibility.

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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

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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”

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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”

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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

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How Is the Premium ForAn Option Determined?

Question: What would you be willing to pay forthe right to sell a futures contract at $3.00 if thecurrent futures price is $2.80?

Answer: If the premium is under $.20, youcould make a profit by exercising theoption (sell @ $3) and buy a futures contract for $2.80 at the same time, making a $20profit.

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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

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Components of Premium

• Intrinsic Value

+

• Time Value

=

Premium

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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

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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.

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Components of Time Value

• Time

• Volatility

• Interest rates

• Underlying futures price

• Strike price

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Time Decay

0

0.25

0.50

0180 90Days to expiration

Time value

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Options are said to be:

In the money (ITM) – have intrinsic value

Out of the money (OTM) – have no intrinsic value

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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

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Payoff diagram – Long Call

$0.50

$1.00

0

$1.00

$0.50

Profit

Loss

$7.50$7.00$6.50 $8.50$8.00

OTM ITMATM

Buy Call

@$.50/Bu

Beans Price at Expiration

Strike Price

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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

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Payoff diagram – Long Put

$0.25

$0.50

0

$0.50

$0.25

Profit

Loss

$7.50$7.25$7.00 $8.00$7.75

ITM OTMATM

Buy Put

@$.25/Bu

Beans Price at Expiration

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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

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Reasons Why a Producer Might Buy Options

Action Reason

Buys a Put

Buys a Call

Buys a Call

Needs price protection (floor) for crops.

Needs price protection (ceiling) on feed requirements.

Has sold crops and believes prices are going to rise.

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OPTIONS WORKSHEET

STRIKE PRICE ___________

- EXPECTED BASIS ___________

- PREMIUM ___________

- COMMISSION ___________

= EXPECTED MIN NET

SELLING PRICE ___________

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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

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Pricing Alternatives(Falling Market)

Date Cash Sale Forward PreHarvest Option At Harvest Contract Hedge ($.20 prem.)

Spring $3.40 Sell Dec Buy PutPlanting offer @$4 $4 strike

Fall Sell@2.50 Deliver Buy Dec Sell Dec@$4Harvest @$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

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Pricing Alternatives(Rising Market)

Date Cash Sale Forward Pre-Harvest Option At Harvest Contract Hedge ($.20 prem.)

Spring $3.40 Sell Dec Buy PutPlanting offer @$4 $4 strike

Fall Sell@4.50 Deliver Buy Dec Let OptionHarvest @$3.40 @$5 Lapse/Die

Net Return $4.50 $3.40 $4.50 cash $4.50 cash -$1 fut.=$3.50 -.20=$4.30