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 specified
period of time.
1
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.
2
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
3
Options are popular because:
1) Price Insurance.
2) Limited financial obligation.
3) Marketing flexibility.
4
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
5
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”
6
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”
7
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
8
How Is the Premium For
An 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.
9
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
10
Components of Premium
• Intrinsic Value
+
• Time Value
=
Premium
11
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
12
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.
13
Components of Time Value
• Time
• Volatility
• Interest rates
• Underlying futures price
• Strike price
14
Time Decay
Time value
0.50
0.25
0
180
90
Days to expiration
0
15
Options are said to be:
In the money (ITM) – have
intrinsic value
Out of the money (OTM) –
have no intrinsic value
16
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
Profit
Buy Call
$1.00
@$.50/Bu
$0.50
Beans
Price at
Expiration
Strike Price
0
$6.50
$7.00
$7.50
$8.00
$8.50
$0.50
$1.00
OTM
ATM
ITM
Loss
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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
Profit
Buy Put
$0.50
@$.25/Bu
$0.25
Beans
Price at
Expiration
0
$7.00
$7.25
$7.50
$7.75
$8.00
$0.25
$0.50
ITM
ATM
OTM
Loss
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What Happens to An Option
Which 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
Needs price protection
(floor) for crops.
Needs price protection
(ceiling) on feed
requirements.
Has sold crops and believes
prices are going to rise.
Buys a Call
Buys a Call
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OPTIONS WORKSHEET
STRIKE PRICE
___________
- EXPECTED BASIS
___________
- PREMIUM
___________
- COMMISSION
___________
23
Put Option Example
Date
Cash
Market
Spring
Futures
Market
Sell Dec. @$4
Harvest
$2.50
Dec. Fut=$3
Sell Dec@$4
Buy Dec@$3
Option
Market
Buy Dec Put
Strike=$4
Premium=$.20
Sell Dec Put
Strike=$4
Premium=$1.20
GAIN……………………..$1………………$1
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Pricing Alternatives
(Falling Market)
Date
Cash Sale
At Harvest
Spring
Planting
Fall
Harvest
Sell@2.50
Net Return
$2.50
Forward
Contract
PreHarvest
Hedge
Option
($.20 prem.)
$3.40
offer
Sell Dec
@$4
Buy Put
$4 strike
Deliver
@$3.40
Buy Dec
@$3
Sell Dec@$4
Buy Dec@$3
$3.40
$2.50 cash
+$1 fut.=$3.50
$2.50 cash
+$1 fut-.20=$3.30
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Pricing Alternatives
(Rising Market)
Date
Cash Sale
At Harvest
Spring
Planting
Fall
Harvest
Sell@4.50
Net Return
$4.50
Forward
Contract
Pre-Harvest
Hedge
Option
($.20 prem.)
$3.40
offer
Sell Dec
@$4
Buy Put
$4 strike
Deliver
@$3.40
Buy Dec
@$5
Let Option
Lapse/Die
$3.40
$4.50 cash
-$1 fut.=$3.50
$4.50 cash
-.20=$4.30
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