Commodity Options Markets. Options Markets H Are more complex than futures with much more complicated terminology and strategies H Commodity options allow.

Commodity Options Commodity Options MarketsMarkets

Commodity Options Commodity Options MarketsMarkets

Options MarketsOptions MarketsOptions MarketsOptions Markets

Are more complex than futures with Are more complex than futures with much more complicated much more complicated terminology and strategiesterminology and strategies

Commodity options allow you to Commodity options allow you to either have a short or long futures either have a short or long futures position at a particular futures price, position at a particular futures price, if you want it, or or provide a if you want it, or or provide a position to the buyer if they want it. position to the buyer if they want it.

OptionOptionOptionOption

Contract between two parties that Contract between two parties that conveys a conveys a rightright but not an but not an obligationobligation to buy or sell a specific to buy or sell a specific commodity futures contract at a commodity futures contract at a specific price within a specific time specific price within a specific time period for a premium.period for a premium.

Pay premium if buy, receive if sell.Pay premium if buy, receive if sell.

Options marketsOptions marketsOptions marketsOptions markets

Traded on major futures exchanges Traded on major futures exchanges as adjunct to most heavily traded as adjunct to most heavily traded futures contractsfutures contracts

Options were made legal again in Options were made legal again in mid-1980s after 50 years; prior mid-1980s after 50 years; prior history of “bucket shops” fleecing history of “bucket shops” fleecing customers led to their bancustomers led to their ban

Options marketsOptions marketsOptions marketsOptions markets

Options on cash products were not Options on cash products were not legal unless delivery was required; legal unless delivery was required; others had to be traded on an others had to be traded on an exchangeexchange

Now CFTC is beginning a trial Now CFTC is beginning a trial options program which allows some options program which allows some merchandisers to offer options merchandisers to offer options contracts on cash productscontracts on cash products

Types of OptionsTypes of OptionsTypes of OptionsTypes of Options

CALLCALL

Right to Long PositionRight to Long Position

Buy (Long)Buy (Long) Sell (Short) Sell (Short)Right to AcquireRight to Acquire Obligation to Obligation to

Long PositionLong Position Deliver Long Deliver Long

Types of OptionsTypes of Options Types of OptionsTypes of Options

PUTPUT

Right to Short PositionRight to Short Position

Buy (Long)Buy (Long) Sell (Short) Sell (Short)Right to AcquireRight to Acquire Obligation to Obligation to

Deliver Deliver

Option ComponentsOption ComponentsOption ComponentsOption Components

Underlying Underlying Commodity Commodity FuturesFutures

Strike PriceStrike Price

Expiration DateExpiration Date

SellerSeller

BuyerBuyer

PremiumPremium

Components of Option PremiumComponents of Option PremiumComponents of Option PremiumComponents of Option Premium

Intrinsic ValueIntrinsic Value

+ Time Value+ Time Value

TOTAL VALUETOTAL VALUE

Intrinsic ValueIntrinsic ValueIntrinsic ValueIntrinsic Value

Strike Price minusStrike Price minus

current Futures Pricecurrent Futures Price

Only “better” strike prices vs. Only “better” strike prices vs. futures have intrinsic value;futures have intrinsic value;

Time ValueTime ValueTime ValueTime Value

Volatility of Underlying FuturesVolatility of Underlying Futures

Higher implies bigger time valueHigher implies bigger time value

Interest RatesInterest Rates

premiums vary directly with interest premiums vary directly with interest rates for calls; opposite for puts.rates for calls; opposite for puts.

Time valueTime valueTime valueTime value

Time till expirationTime till expiration

Longer means largerLonger means largerMore opportunity for futures to More opportunity for futures to

movemoveDeclines faster as expiration nearsDeclines faster as expiration nears

Premium valuePremium valuePremium valuePremium value

Is an option fairly priced?Is an option fairly priced?Sophisticated computer programs Sophisticated computer programs

are available, and used by are available, and used by professionalsprofessionals

But which option makes the most But which option makes the most sense for you?-- a difficult issue.sense for you?-- a difficult issue.

Put and call valuesPut and call valuesPut and call valuesPut and call values

Higher when the option offers a Higher when the option offers a better deal than the current futures better deal than the current futures price levelprice level

Puts--futures lower than strike pricePuts--futures lower than strike priceCalls--futures higher than strikeCalls--futures higher than strike

PutPutPutPut

Out-of-the-moneyOut-of-the-money

Strike Price < Futures PriceStrike Price < Futures Price

At-the-moneyAt-the-money

Strike Price = Futures PriceStrike Price = Futures Price

In-the-moneyIn-the-money

Strike Price > Futures PriceStrike Price > Futures Price

CallCallCallCall

In-the-moneyIn-the-money

Strike Price < Futures PriceStrike Price < Futures Price

At-the-moneyAt-the-money

Strike Price = Futures PriceStrike Price = Futures Price

Out-of-the-moneyOut-of-the-money

Strike Price > Futures PriceStrike Price > Futures Price

HedgesHedgesHedgesHedges

Futures HedgeFutures HedgeUsed to establish a price levelUsed to establish a price level

Must post marginMust post marginOptions HedgeOptions Hedge

Used to establish floor or ceiling price.Used to establish floor or ceiling price.

No margin required for buyers.No margin required for buyers.

Price insurance.Price insurance.

Operating RealitiesOperating RealitiesOperating RealitiesOperating Realities

Alternative to futuresAlternative to futures

Buyers limit purchase or sales Buyers limit purchase or sales prices, but can benefit more prices, but can benefit more than futures from price than futures from price moves the “other” direction.moves the “other” direction.

Operating realitiesOperating realitiesOperating realitiesOperating realities

Ratio of changes in premium Ratio of changes in premium vs futures= DELTAvs futures= DELTA

Option premiums change Option premiums change slower than futures contract slower than futures contract valuesvalues

Standard strategiesStandard strategiesStandard strategiesStandard strategies

Buy put to establish minimum Buy put to establish minimum selling priceselling price

Buy call to establish maximum Buy call to establish maximum purchase pricepurchase price

Can convert to futures, take Can convert to futures, take opposite options position, or let opposite options position, or let expireexpire

Evaluation of Option HedgesEvaluation of Option HedgesEvaluation of Option HedgesEvaluation of Option Hedges

Long hedge by buying callsLong hedge by buying calls

Call Strike + Premium Call Strike + Premium ++ Expected Expected Basis + Commission = CeilingBasis + Commission = Ceiling

Short hedge by buying putsShort hedge by buying puts

Put Strike - Premium Put Strike - Premium ++ Expected Expected Basis - Commission = Floor PriceBasis - Commission = Floor Price

CommissionCommissionCommissionCommission

Charged at half turn rates Charged at half turn rates Buy or sell and expireBuy or sell and expire 1/21/2Buy and sellBuy and sell 1/2 + 1/21/2 + 1/2Buy and convert to Buy and convert to

futures and futures and 1/2 + 1/2 + 1/21/2 + 1/2 + 1/2

reverse positionreverse position

Buy callBuy callBuy callBuy call

Buy Dec $2.80 call option at $.31Buy Dec $2.80 call option at $.31

Expect basis of $-.12Expect basis of $-.12

Minimum purchase price = ??Minimum purchase price = ??

In October, sell call at $.03;In October, sell call at $.03;

buy corn at $2.68;buy corn at $2.68;

Net cost = ??Net cost = ??

Buy callBuy callBuy callBuy call

Buy Dec $2.80 call option at $.31Buy Dec $2.80 call option at $.31


Min. purchase price = 2.80 + .31 Min. purchase price = 2.80 + .31

- .12 + comm = 2.99 + .005 or .01- .12 + comm = 2.99 + .005 or .01

In October, sell call at $.03;In October, sell call at $.03; buy corn at $2.68; buy corn at $2.68;

Net cost = 2.68 + .31 - .03 + .01 = 2.97Net cost = 2.68 + .31 - .03 + .01 = 2.97

Buy putBuy putBuy putBuy put

Buy Dec $2.80 put option at $.31Buy Dec $2.80 put option at $.31


Minimum selling price = ??Minimum selling price = ??

In October, sell put at $.03;In October, sell put at $.03;

sell corn at $2.68;sell corn at $2.68;

Net selling price = ??Net selling price = ??

Options Assignment 1Options Assignment 1Options Assignment 1Options Assignment 1

Assume local basis of $-.25, and 1/2 turn Assume local basis of $-.25, and 1/2 turn commission of 1/2 cent/bu.commission of 1/2 cent/bu.

Calculate February minimum selling and Calculate February minimum selling and maximum purchase prices for:maximum purchase prices for:corncornsoybeans soybeans

based on today’s close. based on today’s close.

Options assignment 1Options assignment 1Options assignment 1Options assignment 1

On February 26, assume relevantOn February 26, assume relevant

Soybean futuresSoybean futures 4.00 or 5.004.00 or 5.00

Corn futuresCorn futures 1.50 or 2.50 1.50 or 2.50

and basis is what you expected.and basis is what you expected.What are your net results??What are your net results??Compare those results with a futures Compare those results with a futures

hedge instead of options?hedge instead of options?


Use today’s closing futures/options Use today’s closing futures/options prices for lean hogs, and calculate prices for lean hogs, and calculate the:the:

Assume March 15 delivery, 74 % Assume March 15 delivery, 74 % dress %, $3.00 basis (carcass), $25 dress %, $3.00 basis (carcass), $25 half turn commissionhalf turn commissionexpected hedged live sales price expected hedged live sales price best options-based min cash pricebest options-based min cash price

Selling optionsSelling optionsSelling optionsSelling options

Unlimited risk; margin requiredUnlimited risk; margin requiredCan be used to acquire premium Can be used to acquire premium

income to supplement cash market income to supplement cash market income income

Caps revenue or cost potentialCaps revenue or cost potentialSometimes used to offset premium Sometimes used to offset premium

costs in complex options strategiescosts in complex options strategies

Selling optionsSelling optionsSelling optionsSelling options

Best left to the experts and Best left to the experts and

those willing to take on high riskthose willing to take on high risk

Amateurs beware!!Amateurs beware!!Can use to supplement cash prices, but Can use to supplement cash prices, but

establishes cap on those pricesestablishes cap on those pricesCan use buy put-sell call combo to Can use buy put-sell call combo to

simulate a futures short hedgesimulate a futures short hedge

Sell Cash / Long CallSell Cash / Long CallSell Cash / Long CallSell Cash / Long Call

Sell cash grain & buy a call Sell cash grain & buy a call

Often advocated by market Often advocated by market strategistsstrategists

Is speculative, since no cash Is speculative, since no cash position. But keeping cash is position. But keeping cash is speculative too.speculative too.


Advantages:Advantages:

Minimum Selling Price EstablishedMinimum Selling Price Established

Immediate Cash FlowImmediate Cash Flow

Market Rally Improves Selling PriceMarket Rally Improves Selling Price

No Storage Related No Storage Related Costs/ProblemsCosts/Problems

Contract GuaranteedContract Guaranteed


DisadvantagesDisadvantages

Cash price reduced by premium Cash price reduced by premium paidpaid

Loss of time value would have to Loss of time value would have to be made up by changes in be made up by changes in futures pricesfutures prices

Speculation, since no cash Speculation, since no cash positionposition

Sell Cash / Long Call EvaluationSell Cash / Long Call EvaluationSell Cash / Long Call EvaluationSell Cash / Long Call Evaluation

In Falling MarketIn Falling Market

Min. Price = Cash Price - Call Min. Price = Cash Price - Call PremiumPremium

In Rising MarketIn Rising Market

Max. Price = Cash Price + Call Max. Price = Cash Price + Call Option Profit Option Profit

( sell premium minus buy ( sell premium minus buy premium)premium)

Sell Cash/Long Call EvaluationSell Cash/Long Call EvaluationSell Cash/Long Call EvaluationSell Cash/Long Call Evaluation

Assume At Harvest (Nov 19, 1998)Assume At Harvest (Nov 19, 1998)

Dec. Futures = $2.42, Cash = Dec. Futures = $2.42, Cash = $2.13$2.13

March ‘99 Corn futures= $2.53March ‘99 Corn futures= $2.53

March 2.60 Calls @ $0.21March 2.60 Calls @ $0.21

Expected Basis Feb. 25 vs Mar. Expected Basis Feb. 25 vs Mar. Futures = - $0.20;comm = $.01Futures = - $0.20;comm = $.01

Storage @ $0.04 per monthStorage @ $0.04 per month

Sell Cash / Long Call ExampleSell Cash / Long Call Example

Hold and Store StrategyHold and Store Strategy

MarchMarch CashCash StorageStorage -- = =

NetNetFuturesFutures PricePrice CostCost PricePrice

A.A. 2.25 2.25 2.052.05 .12.121.931.93

B.B. 2.80 2.80 2.602.60 .12.122.482.48

C.C. 3.20 3.20 3.003.00 .12.122.882.88

Sell Cash / Long Call ExampleSell Cash / Long Call ExampleSell Cash / Long Call ExampleSell Cash / Long Call Example

Sell Cash / Long Call StrategySell Cash / Long Call Strategy

MarchMarch CashCash OptionsOptions NetNet ++

= = FuturesFutures PricePrice Profit/LossProfit/Loss Price Price

A.A. 2.25 2.25B.B. 2.80 2.80C.C. 3.20 3.20



MarchMarch CashCash OptionsOptions Net Net ++

= = FuturesFutures PricePrice Profit/LossProfit/Loss Price Price

A.A. 2.25 2.25 2.132.13 -.21 -.21B.B. 2.80 2.80 2.132.13 -.21 -.21correct?correct?C.C. 3.20 3.20 2.132.13 +.39+.39



MarchMarch CashCash OptionsOptions Net Net ++ = =

FuturesFutures PricePrice Profit/LossProfit/Loss Price Price

A.A. 2.25 2.25 2.132.13 -.21 -.21 1.921.92B.B. 2.80 2.80 2.132.13 -.21 -.21wrong?wrong? 1.921.92C.C. 3.20 3.20 2.132.13 +.39+.39 2.522.52minus commissions (How much?)minus commissions (How much?)

Cattle feeder options hedgeCattle feeder options hedgeCattle feeder options hedgeCattle feeder options hedge

Buy a fed cattle putBuy a fed cattle putSell a fed cattle callSell a fed cattle callGets premium from selling call to Gets premium from selling call to

offset premium paid to buy putoffset premium paid to buy putIf at same strike prices, it’s like a If at same strike prices, it’s like a

futures short position--not worst futures short position--not worst case pricecase price

Options/futures comboOptions/futures comboOptions/futures comboOptions/futures combo

Sell futures, buy call -- option is like Sell futures, buy call -- option is like a stop lossa stop loss

Buy futures, buy a put -- option is Buy futures, buy a put -- option is like a stop losslike a stop loss

In the short run, option may not In the short run, option may not fully offset futures price changesfully offset futures price changes

Delta affects hedge effectivenessDelta affects hedge effectivenessDelta affects hedge effectivenessDelta affects hedge effectiveness

Premium changes differ from Premium changes differ from futures and cash price changes!! futures and cash price changes!! Changes in out-of-the-money Changes in out-of-the-money options are low vs. futuresoptions are low vs. futures

Changes for in the money options Changes for in the money options get close to 1 : 1get close to 1 : 1

Changes at-the-money are near .50Changes at-the-money are near .50

Out-of-the-money option delta values Out-of-the-money option delta values increase as time to maturity increasesincrease as time to maturity increases

In-the-money option delta values In-the-money option delta values decrease as time to maturity increasesdecrease as time to maturity increases

At-the-money option delta values are At-the-money option delta values are not significantly affected by time to not significantly affected by time to maturity until near expirationmaturity until near expiration

Delta or hedge effectivenessDelta or hedge effectivenessDelta or hedge effectivenessDelta or hedge effectiveness

When are options When are options a good choice?a good choice?When are options When are options a good choice?a good choice?

When available margin money is When available margin money is limited?limited?

When price risk is very high, and When price risk is very high, and sustained price moves could be sustained price moves could be large?large?

When production risk is high?When production risk is high?

But, premiums can be high!But, premiums can be high!

OptionsOptionsOptionsOptions

Offer a complicated risk management Offer a complicated risk management alternativealternative

Offers some risk reduction at known Offers some risk reduction at known up-front costup-front cost

Always will be between cash or Always will be between cash or futures in profitabilityfutures in profitability

Complicated strategies considered in Complicated strategies considered in senior and graduate mktg classessenior and graduate mktg classes

You should be able to You should be able to evaluate payoffs from:evaluate payoffs from:You should be able to You should be able to evaluate payoffs from:evaluate payoffs from:

Options hedgeOptions hedgeFutures hedgeFutures hedgeSell cash or contract, buy callSell cash or contract, buy callCash only (store?)Cash only (store?)Forward contractForward contractHedge to arriveHedge to arrive and similar and similar Price laterPrice later mktg strategies mktg strategies


You are considering buying 1000 You are considering buying 1000 20# early weaned feeder pigs next 20# early weaned feeder pigs next month @ $50/hd, buying corn, and month @ $50/hd, buying corn, and selling 250# hogs 5 months later.selling 250# hogs 5 months later.

Assume 3# corn per pound of gain, Assume 3# corn per pound of gain, other feed and operating costs of other feed and operating costs of $45 , $13 fixed costs per pig, 2% $45 , $13 fixed costs per pig, 2% death loss death loss


Assume live hogs have 74% dressing Assume live hogs have 74% dressing %, and your hogs receive $2 over %, and your hogs receive $2 over CME futures mkt. pricesCME futures mkt. prices

Assume corn prices are $.20/bu. Assume corn prices are $.20/bu. below CBOT, delivered your farmbelow CBOT, delivered your farm

Calculate expected profit per head Calculate expected profit per head using today’s (a) futures; (b) optionsusing today’s (a) futures; (b) options

Commodity Options Markets. Options Markets H Are more complex than futures with much more complicated terminology and strategies H Commodity options allow.

Documents

particular futures price

futures lower

futures pricein

futures higher

futures priceout

long futures position

premium vs futures

specific price