AgVentures Grain Marketing Options on Future Contracts

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Facilitator’s Notes – Options

AgVentures

Grain Marketing

Facilitator’s Notes

Options on Future Contracts

TIME ALLOWED:

OBJECTIVE(S):

1.

2.

3.

Understand the basic terminology and fundamentals of options trading.

Understanding of how options work.

Understand how to use options to hedge: Basic option strategies.

INSTRUCTIONS:

In conjunction with the power point slides the following script will enable the facilitator to give basic understanding about the options on commodity futures to the seminar or workshop participants. (file: 10-Options.ppt)

Slide 1:

The definition of an option is “Contract between two parties that convey to a buyer a right, but not an obligation, to buy (cal) or sell (put) a specific commodity at a specific price within a specific time period for a premium.”

Understanding options on agricultural commodities will give great flexibility in the marketing of grain. You can employ variety of strategies using these tools along with others such as forward cash contracts, futures contracts or synthetics.

Look the definition of an option one more time: An option is simply the right, but not the obligation, to buy or sell a futures contract at some predetermined price at anytime within a specified time period.

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Facilitator’s Notes – Options

Slide 2:

Few terms to understand:

Strike price or exercise price: The predetermined futures price at which the futures contract may be bought (for a call) or sold (for a put) is called the strike or exercise price.

The premium is the amount paid for an option.

Slide 3:

An option gives you a choice. One example to let you understand the concept of options is using the example of option to purchase land.

Let us assume a farmer is interested in buying some land from his neighbor. The neighbor is offering to sell 100 acres of adjoining crop land at a price of $1600 an acre. The farmer would like to own the land but, for any number of possible reasons, he is unable or unwilling to purchase it at the present time. So, to lock in the right to buy the acreage at that price, he persuades the neighbor to sell him an option to purchase the land at any time of his choosing during the next six months. For each acre he is willing to pay an advance fee of $12 (total $1200) to get the rights from the seller to buy the land.

If the producer subsequently decides to buy the land, the neighbor is obligated to sell it to him at that predetermined or strike price of $1600. But the option does not obligate him. If the farmer does not want to purchase the land, he can simply let the option expire.

The above is an example of buying a call option which gave the purchaser of option (farmer) the right to buy the underlying asset (land) at the agreed upon price or predetermined price of $1600

(strike price or exercise price) with in the next six months by paying an initial fee of $1200

(premium).

Understand that the buyers of option have the right to exercise. The sellers have obligation to fulfill the rights of buyers in exchange for the premiums.

Slide 4:

Options on agricultural commodity futures will provide price insurance, limited financial obligation and lots of marketing flexibility to the producers. An option buyer will limit his risks while retaining the potential for unlimited profits. Options offer the short hedger a means to protect against declining prices while retaining the ability to profit form rising price. Basically a producer can use options as a sort of insurance to protect the business in case of unintended price moves (e.g. declining prices).

Options buyers will have limited financial obligation. The maximum that a buyer of an option can loose is the premium paid or the cost of buying the option. Unlike futures markets option buyer do not need to open a margin account or meet margin calls. The option premiums are kind of act like the regular insurance premiums. The greater the price protection desired the higher the option premiums that needs to pay. You get to choose the level of price protection and need to pay the associated premium in the options markets.

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Facilitator’s Notes – Options

Slide 5:

There are two different types of options. Put and Call options. Never get confused about this. Put and

Call options are separate and distinct option contracts, not opposite sides of the same transaction.

Slide 6:

A put option gives the option buyer the right, but not the obligation, to sell (go short) a particular futures contract at a specified price at any time during the life of an option.

Slide 7:

A call option gives the option buyer the right, but not the obligation, to buy (go long) a particular futures contract (such as December corn futures contract) at a specified price at any time during the life of the option.

Slide 8:

Put option gives the buyer protection against the declining price without giving up the chance to benefit from rising prices. A put option hedge will enable to set the minimum or floor price.

The buyer of call option obtains protection against rising prices (e.g. a feed lot operator who wants to buy feed grains needs protection against rising prices) without giving up the chance to benefit from lower prices. Call options can also be used to speculate in the increase of prices at a future time and can take advantage of seasonal price advances.

Slide 9:

The premiums of the options are traded in the Chicago markets by the open out cry method where the supply and demand will determine their value or premiums.

Let us look at the following question:

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: The premium should be greater than or equal to $0.20 (difference between strike price and current futures price). If the premium is under $.20, you could make a profit by exercising the option

(sell underlying futures at @ $3) and buy a futures contract for $2.80 at the same time. These arbitrage activities will keep the premiums in line. Usually the premium will be greater than $0.20 depending upon the time that is remaining for this option to expire.

Let us discuss what goes into an option premium in the next slide.

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Facilitator’s Notes – Options

Slide 10, 11 & 12:

The premium paid to buy an option will have two parts. One portion is called as intrinsic value and the other one is time value.

Premium = Intrinsic value + Time value.

The amount that an option is in the money is called intrinsic value. For a put option if the strike price is above the underlying futures price, the put is said to be in the money by the difference between the two values. For a call option if the strike price is below the underlying futures price, the call is said to be in the money by the difference between the two values. This is equal to the intrinsic value of the option. If the premium paid is more than this intrinsic value to purchase the option the remaining portion of the premium after intrinsic value is the time value.

For example, if a corn put option has a strike price of $2.60 and the underlying futures price is $2.30, the put option will have an intrinsic value of 30 cents.

Slide 13:

Simply stated, time value is equal to the premium less the intrinsic value. This reflects the amount of money buyers are willing to pay in hope that an option will be worth exercising at or before expiration of the option.

Time value of the option depends upon the time period left for the option to expire. If there is more time for the option to expire, the greater will be the time value. This is because there will be greater likelihood that the option may go into the money in the future for which the seller needs to be compensated. Usually decreases with length of time until expiration, but does increase as price volatility of the underlying futures contract increases.

Slide 14:

Two primary factors affect the time value:

1.

2.

The length of time remaining until expiration.

The volatility of the underlying futures price.

Other factors such as underlying futures price, strike price and general interest levels in the economy will also influence the option premiums.

Usually decreases with length of time until expiration, but does increase as price volatility of the underlying futures contract increases.

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Facilitator’s Notes – Options

Slide 15:

All else remaining equal, the more time an option has until expiration, the higher its premium because it has more time to increase in value. But the options time value will erode much rapidly as the option approaches expiration. An option value at the expiration will be equal to its intrinsic value

– the amount by which it is in the money. This is why options are sometimes described as “decaying assets”.

Slide 16:

In-the-Money (ITM) options have intrinsic value where as Out-of the-Money (OTM) options have no intrinsic value. They only have time value left in the premiums. What is meant by ITM and

OTM? Let us know about these in the next slide.

Slide 17:

An option whose strike price is roughly the same as the underlying futures price is said to be At-the-

Money, while an option that would result in a loss if exercised is said to be Out-of the-Money. An option that would result in a profit if exercised is said to be In-the-Money.

A call option is said to be:

In-the-Money (ITM) If Strike price is less than Futures price.

At-the-Money (ATM) If Strike price equal to Futures price.

Out-of-the-Money (OTM) If Strike price greater than Futures price.

Slide 18:

To understand the above concepts let us take up the example of a long call. If a buyer buys the call it gives him the right to buy the underlying commodity futures at the strike price. Let us take a soybean call option that was bought by paying a premium of $0.50 per bushel at a strike price of $7.50. In the pay off diagram where the strike price equals to the underlying futures price is called the At-the-

Money portion. The portion where the underlying futures price exceeds the strike price is called as

In-the-Money (ITM). The portion where the underlying futures price is below the strike price is called as Out-of the-Money (OTM). As the underlying futures price increase the call option will go into the money (ITM).

Slide 19:

A put option is said to be:

In-the-Money (ITM) If Strike price is greater than Futures price.

At-the-Money (ATM) If Strike price equal to Futures price.

Out-of-the-Money (OTM) If Strike price less than Futures price.

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Facilitator’s Notes – Options

Slide 20:

To understand the above concepts let us take up the example of a long put. If a buyer buys the put it gives him the right to sell the underlying commodity futures at the strike price. Let us take a soybean put option that was bought by paying a premium of $0.25 per bushel at a strike price of $7.50. In the pay off diagram where the strike price equals to the underlying futures price is called the At-the-

Money portion. The portion where the underlying futures price exceeds the strike price is called as

Out-of the-Money (OTM). The portion where the underlying futures price is below the strike price is called as In-the-Money (ITM). As the underlying futures price decrease the call option will go into the money (ITM).

Slide 21:

There are three actions that you can take to close an options position:

Neither ATM nor OTM options are worth exercising. You let them expire.

You will exercise an option if it is ITM and by doing so you are selling (put option) or buying (call option) the underlying futures at the strike price.

You can also close the (ITM) option position by taking opposite action in order to offset the positions by either selling or buying the same type of option at the premiums that are trading.

Slide 22:

Strategies in using Options

Let us look at some of the reasons a producer might buy options.

1) Producer buys a put option to establish a minimum price or floor price:

A producer who owns grain and anticipates selling it at a later time fears that the price may decline in the future. He can establish a floor price or the minimum price that he can get at a later time by purchasing a put option. This floor price equals the strike price or exercise price minus the premium, plus or minus the basis. Before establishing a floor price it is always better to compare the floor price with the cost of production.

For example assume that your cost of production to produce a bushel of corn is $2.00. Further assume that December corn is $2.50 per bushel and the historical basis at harvest is $0.15 under. The premium of December put option is $0.10. Using these you can arrive at a floor price of $2.25 which is exercise price $2.50 minus $0.10 premium minus $0.15 basis.

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Facilitator’s Notes – Options

2) Producer buys a call option to establish a maximum price:

If you are livestock feeder or feedlot operator and anticipate a grain purchase and expect an increase in price in the future, you can purchase a call option to establish a ceiling or maximum price. If the price raise in the future you will be protected where as if the price declines you can take advantage.

When you buy a call option the ceiling or maximum price that was set equals strike price plus premium and plus or minus the basis.

For example assume that you decide to buy $2.50 call for $0.20 per bushel. The basis at the time of actual purchase is minus $0.15. In this case, the ceiling price is $2.55 per bushel, which is $2.50 strike price minus the $0.15 basis plus the $0.20 premium. Even if the price rises you are protected and pay only the maximum amount of $2.55.

3) Producer buys a call to replace storage:

At the harvest time a producer can sell the crop in the cash market without looking for storage. This provides him the money needed to payoff loans and reduce the interest expenses. But he is going to loose if the prices advance in the future which will happen normally during the marketing year. In order to profit from the price increase a producer can buy a call option after selling the crop in the cash market. He could use some of the proceeds from the sale of crop to finance the option premiums. If the price in the future goes up, his call option will go into the money and gives the profit from the price increase. If in the future the prices goes down the option will expire. The maximum amount of loss is limited to the premium paid for the call option.

This strategy will help the producer to avoid storing the crop and the associated risks i.e. physical quality deterioration, handling and other charges. If also eliminates the basis risk associated with storage.

Slide 23:

In order to know the minimum net selling price we can you the template shown. For example, if we buy a December put option of corn at a strike price of $4.00 by paying a premium of $0.20 and the expected basis is minus $0.10 with a commission of $0.01 per bushel the minimum net selling price using this option is $2.69.

Let us assume that basis will be zero and if we do not consider the commissions in the next example.

Slide 24:

Let us assume that the expected basis will be zero and we do not consider the commissions in this example to compare net returns coming from cash, futures and options hedge.

If we stayed in the cash market with out hedging the final selling price will be $2.50.

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Facilitator’s Notes – Options

If we took a short hedge position in the futures market and lifted the hedge when the futures price is at $3.00, the futures market gain is $1.00, which we will add to the cash sale price to arrive at the net price.

If we bought a put option at a strike price of $4.00 by paying a premium of $0.20 when the futures price is at $3.00, the put option went into the money (ITM) with a gain is $1.00 that will be added to the cash sale price to arrive at the net price.

Slide 25:

Following the same example let us compare the final net selling price using cash, forward contract, futures and options hedge when the market prices are falling. In cash market the net price will be

$2.50. Using forward contract the net price will be $3.40. In short hedge situation using the futures contract the net price will be $3.50.Using put option the net price will be $3.30. Note that forward contract locks-in a price and both the futures hedge and put option has given price protection in the falling market.

Slide 26:

Similarly, following the same example, let us compare the final net selling price using cash, forward contract, and futures and options hedge when the market prices are rising. In cash market the net price will be $4.50. Using forward contract the net price will be $3.40. In short hedge situation using the futures contract the net price will be $3.50.Using put option the net price will be $4.30. Note that forward contract locks-in a price and the futures hedge did not allow us to take advantage of rising prices. Where as put option expired because it is OTM has enabled to take advantage of increasing market.

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Facilitator’s Notes – Options

Exercises

Exercise 1: Put Options

Understand the concepts of “intrinsic” and “time value

Understand the concept of “in the money” and “out of the money” options

Determine the “intrinsic” value and “time” value for each of the options. Which options are “in the money?” “Out of the money?”

Answer: ITM = In-the-Money; OTM = Out-of-the-Money

December Corn @ $2.46

Strike Price Premium Intrinsic Value Time Value

$2.60 (ITM) 28 14 14

$2.50 (ITM)

$2.40 (OTM)

$2.30 (OTM)

$2.20 (OTM)

$2.10 (OTM)

$2.00 (OTM)

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Facilitator’s Notes – Options

Exercise 2: Put Options

Learn the basics of using put options to protect a price

You have 5,000 bushels of corn to sell. You purchase a December put option with a strike price of

$2.40/bushel. The premium is $0.16 per bushel. You sell cash corn in November at Grainville

Elevator (CBOT price is $2.10). Calculate the net price you will receive for your corn.

Answer:

Strike price = $2.40 ; Put option premium paid = $0.16

November CBOT price is $2.10; The Put option went into the money by $0.30. You will either exercise or offset your position.

If you exercise your right to sell the net selling price will be strike price minus basis minus the premium paid assuming there are no other commission charges i.e. $2.40 -$0.32-$0.16 = $1.92.

Local basis is minus 0.32

If you choose to offset the option position, the gain from the premiums is $0.30 minus $0.16 =

$0.14. You will add this gain to the cash price you receive at the local grain elevator. Local basis is minus 0.32. Local cash price is $2.10-$0.32 = $1.78. The net selling price is $1.92 ($1.78 + $0.14).

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Facilitator’s Notes – Options

Exercise 3 – Future or Put Options

Learn the relative advantages and disadvantages of futures contracts and put options and when to use each tool.

It is March 15. Do you use futures or put options?

July Beans @ $4.73 (today)

July Basis @ 34

Strike Price

$5.00

$4.80

Premium

38

25

$4.60

$4.40

15

7

1.

Net price if you place a hedge today and closed out the contract and sold cash beans in June at CBOT price of $4.43? At CBOT price of $4.93?

Answer:

If June CBOT futures price is $4.43 then the gain from futures transaction will be $ 0.30 ($4.73-

$4.43). Basis is $0.34. So the cash price will be $4.09 ($4.43-$0.34). The net price will be cash price plus gain coming from the futures market. The net selling price is $4.09+$0.30 = $4.39.

If June CBOT futures price is $4.93 then the loss from futures transaction will be minus $0.20

($4.73-$4.93). Basis is $0.34. So the cash price will be $4.59 ($4.93-$0.34). The net price will be cash price minus loss coming from the futures market. The net selling price is $4.59-$0.20 = $4.39.

2.

Net price for each of the options if you buy an option now and close out and sold cash beans in June at CBOT price of $4.43? At CBOT price of $4.93?

Answer:

As determined in question 1 the cash price if futures go to $4.43 is 4.09. The return from the four options choices will be the cash price plus the gain or loss from options. Therefore:

(intrinsic value) – (premium)= return to option + cash price = net price realized

5.00: .57 -.38 = .19 + 4.09 = 4.28

4.80: .37 -.25 = .12 + 4.09 = 4.21

4:60: .17 -.15 = .02 + 4.09 = 4.11

4.40: .00 - .07 =-.07 + 4.09 = 4.02

When cash corn is $4.93 we have:

Local corn price 4.59 (determined in question 1)

5.00: .07 - .38 = -.31 + 4.59 = 4.28

4.80: .00 - .25 = -.25 + 4.59 = 4.34

4.60: .00 - .15 = -.15 + 4.59 = 4.44

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Facilitator’s Notes – Options

4.40: .00 - .07 = -.07 + 4.59 = 4.52

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Month

January

March

May

July

August

September

November

December

Facilitator’s Notes – Options

CBOT Price Data Sheet

Corn Futures

$2.15

$2.21

$2.24

$2.31

-----

$2.37

$2.43

$2.46

Soybean Futures

$5.21

$5.28

$5.33

$5.37

$5.32

$5.21

$5.18

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