ECON 339X:
Agricultural Marketing
Chad Hart
Assistant Professor
chart@iastate.edu
515-294-9911
Econ 339X, Spring 2011
John Lawrence
Professor
jdlaw@iastate.edu
515-294-7801
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 339X, Spring 2011
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 339X, Spring 2011
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 339X, Spring 2011
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 339X, Spring 2011
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 339X, Spring 2011
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 339X, Spring 2011
Option Issues and Choices
The option may or may not have value at
the end
The right to buy at $4.00 has no value if the
market is below $4.00.
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 339X, Spring 2011
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 339X, Spring 2011
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 339X, Spring 2011
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 339X, Spring 2011
Options Premiums
Dec. 2011
Corn Futures
$5.76 per bushel
In-the-money
Out-of-the-money
Econ 339X, Spring 2011
Source: CBOT, 3/20/09
Setting a Floor Price
 Short hedger
 Buy put option
 Floor Price =
Strike Price + Basis – Premium – Commission
 At maturity
 If futures < strike, then Net Price = Floor Price
 If futures > strike,
then Net Price = Cash – Premium – Commission
Econ 339X, Spring 2011
Short Hedge Graph
8
Net Price ($ per bushel)
Sold Dec. 2011 Corn @ $5.76
6
4
2
0
-2
Net = Cash Price + Futures Return
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Futures Return
Net
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-4
Put Option Graph
Net Price ($ per bushel)
8
6
Put Option Dec. 2011 Corn @ $5.80
Premium = $0.77
4
2
0
-2
Net = Cash Price + Put Option Return
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Put Option Return
Net
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-4
Put Option Graph
Net Price ($ per bushel)
8
7
Put Option Dec. 2011 Corn @ $5.80
Premium = $0.77
6
5
4
3
2
1
0
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-1
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Put Option Return
Net
Hedge
Net Price ($ per bushel)
8
6
Out-of-the-Money Put
Put Option Dec. 2011 Corn @ $4.50
Premium = $0.18
4
2
0
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Put Option Return
Net
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-2
In-the-Money Put
Net Price ($ per bushel)
8
6
Put Option Dec. 2011 Corn @ $7.00
Premium = $1.61
4
2
0
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Put Option Return
Net
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-2
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 339X, Spring 2011
Long Hedge Graph
8
Net Price ($ per bushel)
Bought Dec. 2011 Corn @ $5.76
6
4
2
Net = Cash Price – Futures Return
0
-2
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Futures Return
Net
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-4
Call Option Graph
Net Price ($ per bushel)
8
6
Call Option Dec. 2011 Corn @ $5.80
Premium = $0.73
4
2
Net = Cash Price – Call Option Return
0
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Call Option Return
Net
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-2
Call Option Graph
Net Price ($ per bushel)
8
6
Call Option Dec. 2011 Corn @ $5.80
Premium = $0.73
4
2
0
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
00
5.
50
4.
00
4.
50
3.
3.
00
-2
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Call Option Return
Net
Hedge
Combination Strategies
 Option fence
 Buy put and sell call
 Higher floor, but you now have a ceiling
 Put spread
 Buy At-the-money put and sell Out-of-the-money put
 Better net price at middle and higher prices, but no
floor below Out-of-the-money strike price
Econ 339X, Spring 2011
7
Buy Put Option Dec. 2011 Corn @ $5.50
Premium = $0.59
6
5
4
3
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Net w/ Fence
00
8.
50
7.
00
7.
50
6.
00
6.
50
5.
50
4.
00
4.
50
3.
3.
00
2
00
Sell Call Option Dec. 2011 Corn @ $6.50
Premium = $0.50
5.
Net Price ($ per bushel)
8
Fence
7
Buy Put Option Dec. 2011 Corn @ $6.50
Premium = $1.23
6
5
4
3
Futures Price ($ per bushel)
Cash Price
Econ 339X, Spring 2011
Net w/ Spread
00
8.
50
7.
00
7.
50
6.
00
6.
00
5.
50
4.
00
4.
50
3.
3.
00
2
50
Sell Put Option Dec. 2011 Corn @ $5.00
Premium = $0.35
5.
Net Price ($ per bushel)
8
Spread
Combination Strategies
Butterfly
Straddle
Condor
Strangle
These positions can be flipped
Econ 339X, Spring 2011
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 339X, Spring 2011
Class web site:
http://www.econ.iastate.edu/~chart/Classes/econ339/
Spring2011/
Econ 339X, Spring 2011