Lee Schulz
Assistant Professor lschulz@iastate.edu
515-294-3356
Chad Hart
Associate Professor chart@iastate.edu
515-294-9911

 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.

 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.

 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.

 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.

 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.

 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.

 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.

 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

 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

 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

Dec. 2014
Corn Futures
$4.60 per bu.
In-the-money
Out-of-the-money
Source: CME, 2/5/13

 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

Dec. 2014 Corn Futures @ $4.5925
Strike Price @ $4.60
Put Option Return =
Max(0, Strike Price – Futures Price) – Premium – Commission
Premium = $0.36125
Commission = $0.01

Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $4.60
Premium = $0.36125
Net = Cash Price + Put Option Return

Sold Dec. 2014 Corn Futures @ $4.5925
Net = Cash Price + Futures Return

Sold Dec. 2014 Corn Futures @ $4.5925
Net = Cash Price + Futures Return

Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $3.00
Premium = $0.005

Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $6.00
Premium = $1.45

 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

Dec. 2014 Corn Futures @ $4.5925
Strike Price @ $4.60
Call Option Return =
Max(0, Futures Price – Strike Price) – Premium – Commission
Premium = $0.35375
Commission = $0.01

Dec. 2014 Corn Futures @ $4.5925
Strike Price @ $4.60
Net = Cash Price – Call Option Return

Bought Dec. 2014 Corn Futures @ $4.5925
Net = Cash Price – Futures Return

 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

Class web site: http://www.econ.iastate.edu/~chart/Classes/econ337/
Spring2014/
Have a great weekend!