ECON 337:
Agricultural Marketing
Lee Schulz
Assistant Professor
lschulz@iastate.edu
515-294-3356
Econ 337, Spring 2013
Chad Hart
Associate Professor
chart@iastate.edu
515-294-9911
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.
Econ 337, Spring 2013
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.
Econ 337, Spring 2013
Put Option
The Buyer pays the premium and has the
right, but not the obligation, to sell a
futures contract at the strike price.
The Seller receives the premium and is
obligated to buy a futures contract at the
strike price if the Buyer uses their right.
Econ 337, Spring 2013
Call Option
The Buyer pays a premium and has the
right, but not the obligation, to buy a
futures contract at the strike price.
The Seller receives the premium but is
obligated to sell a futures contract at the
strike price if the Buyer uses their right.
Econ 337, Spring 2013
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.
Econ 337, Spring 2013
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.
Econ 337, Spring 2013
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.
Econ 337, Spring 2013
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
Econ 337, Spring 2013
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
Econ 337, Spring 2013
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
Econ 337, Spring 2013
Options Premiums
June 2013
Live Cattle
Futures
$128 per cwt.
In-the-money
Out-of-the-money
Econ 337, Spring 2013
Source: CME, 2/5/13
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
Econ 337, Spring 2013
Put Option Graph
10
Put Option June 2013 Live Cattle @ $128
Net Return ($ per cwt)
8
6
4
Strike Price = $128
Put Option Return =
Max(0, Strike Price – Futures Price) – Premium – Commission
2
0
Premium = $3.275
Commission = $0.01
-2
-4
115
117
119
121
123
125
127
129
131
Futures Price ($ per cwt)
Cash Price
Econ 337, Spring 2013
Put Option Return
Net
133
135
Net Return ($ per cwt)
135
Put Option Graph
Put Option June 2013 Live Cattle @ $128
Premium = $3.275
130
Net = Cash Price + Put Option Return
125
120
115
110
115
117
119
121
123
125
127
129
131
Futures Price ($ per cwt)
Cash Price
Econ 337, Spring 2013
Put Option Return
Net
133
135
Short Hedge Graph
15
Sold June 2013 Live Cattle @ $128
Net Return ($ per cwt.)
12
9
6
3
0
-3
Net = Cash Price + Futures Return
-6
-9
115
117
119
121
123
125
127
129
Futures Price ($ per cwt.)
Econ 337, Spring 2013
131
133
135
Short Hedge Graph
135
Net Return ($ per cwt.)
Sold June 2013 Live Cattle @ $128
130
125
120
Net = Cash Price + Futures Return
115
110
115
117
119
121 123 125 127 129
Futures Price ($ per cwt.)
Cash Price
Econ 337, Spring 2013
Futures Return
131
Net
133
135
Comparison
Net Price ($ per bushel)
135
130
125
120
115
110
115
117
119
Cash Price
Econ 337, Spring 2013
121 123 125 127 129 131
Futures Price ($ per bushel)
Put Option Return
Net
133
Hedge
135
Out-of-the-Money Put
10
Net Return ($ per cwt)
8
Put Option June 2013 Live Cattle @ $120
Premium = $0.80
6
4
2
0
-2
-4
115
117
119
121
123
125
127
129
131
Futures Price ($ per cwt)
Cash Price
Econ 337, Spring 2013
Put Option Return
Net
133
135
Out-of-the-Money Put
Net Return ($ per cwt)
135
130
Put Option June 2013 Live Cattle @ $120
Premium = $0.80
125
120
115
110
115
117
119
121
123
125
127
129
131
Futures Price ($ per cwt)
Cash Price
Econ 337, Spring 2013
Put Option Return
Net
133
135
In-the-Money Put
Net Return ($ per cwt)
12
Put Option June 2013 Live Cattle @ $132
Premium = $5.625
9
6
3
0
-3
-6
115
117
119
121
123
125
127
129
131
Futures Price ($ per cwt)
Cash Price
Econ 337, Spring 2013
Put Option Return
Net
133
135
In-the-Money Put
Net Return ($ per cwt)
135
Put Option June 2013 Live Cattle @ $132
Premium = $5.625
130
125
120
115
110
115
117
119
121
123
125
127
129
131
Futures Price ($ per cwt)
Cash Price
Econ 337, Spring 2013
Put Option Return
Net
133
135
Comparison
Net Return ($ per cwt)
135
130
125
120
115
5
13
3
13
1
13
9
12
7
12
5
12
3
12
1
12
9
11
7
11
11
5
110
Futures Price ($ per cwt)
Cash
Econ 337, Spring 2013
At the Money
Out of the Money
In the Money
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
Econ 337, Spring 2013
Call Option Graph
2
Net Return ($ per bushel)
Call Option Dec. 2013 Corn @ $6
1.5
1
0.5
Strike Price = $6
Call Option Return =
Max(0, Futures Price – Strike Price) – Premium – Commission
0
Premium = $0.50
Commission = $0.01
-0.5
Futures Price ($ per bushel)
Cash Price
Econ 337, Spring 2013
Call Option Return
Net
8.
00
7.
50
7.
00
6.
50
6.
00
5.
50
5.
00
4.
50
4.
00
3.
50
3.
00
-1
Call Option Graph
Net Return ($ per bushel)
8
7
6
Call Option Dec. 2013 Corn @ $6
Premium = $0.50
5
4
3
2
1
Net = Cash Price – Call Option Return
0
Futures Price ($ per bushel)
Cash Price
Econ 337, Spring 2013
Call Option Return
Net
8.
00
7.
50
7.
00
6.
50
6.
00
5.
50
5.
00
4.
50
4.
00
3.
50
3.
00
-1
Long Hedge Graph
8
Net Return ($ per bushel)
Bought Dec. 2013 Corn @ $5.9375
6
4
2
Net = Cash Price – Futures Return
0
-2
Futures Price ($ per bushel)
Cash Price
Econ 337, Spring 2013
Futures Return
Net
8.
00
7.
50
7.
00
6.
50
6.
00
5.
50
5.
00
4.
50
4.
00
3.
50
3.
00
-4
Comparison
Net Return ($ per bushel)
8
6
4
2
0
Futures Price ($ per bushel)
Cash Price
Econ 337, Spring 2013
Call Option Return
Net
Hedge
0
8.
0
0
7.
5
0
7.
0
0
6.
5
0
6.
0
0
5.
5
0
5.
0
0
4.
5
0
4.
0
0
3.
5
3.
0
0
-2
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
Econ 337, Spring 2013
Class web site:
http://www.econ.iastate.edu/~chart/Classes/econ337/
Spring2013/
Lab in Heady 68.
Econ 337, Spring 2013