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 17 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 18 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 19 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 20 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 21 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 22 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 24 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 25 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 26