Understanding Agricultural Options John Hobert Farm Business Management

Understanding Agricultural Options John Hobert Farm Business Management Program Riverland Community College

Why are Agricultural Options Popular? Options are basically easy to understand as compared to the Futures Hedge. n An options hedger is protected against any “unfavorable price change. ” n A hedger does not have to deposit any margin money or worry about margin calls. n

Why are Agricultural Options Popular? Options allow buyers of agricultural products to set “ceiling” prices to protect against price increases. n Options allow the opportunity to gain from rising markets. (puts) n Options allow the opportunity to gain from price decreases in the market. (calls) n

Why are Agricultural Options Popular? n Options permit producers to establish “floor” prices for protection against falling markets.

What is an Option? n 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.

Option terminology: An option to buy a futures contract is known as a “call option. ” n An option to sell a futures contract is known as a “put option. ” n The predetermined futures price at which the future contract may be bought or sold is called the “strike or exercise price, ” strike price being most commonly used. n

More Option Terminology: The “premium” is the amount paid for an option. n The individual purchasing an options contract is referred to as the “options buyer” or “holder. ” n An options contract is said to be “in the money” when it has intrinsic value. n

Intrinsic values in a nut shell: n An option has an intrinsic value if it would be profitable to exercise the option. u Call Options have intrinsic value when the strike price is below the futures price. u Put Options have intrinsic value when the strike price is above the futures price.

“In the Money” Examples: n Call Option Example: (Long Position) u Dec corn futures price is $2. 50/Bu. u Dec corn call has a “strike price” of $2. 20/Bu. u The contract’s “intrinsic” value is $. 30/Bu. n Put Option Example: (Short Position) u July corn futures price is $2. 50/Bu. u July corn put has a “strike price” of $2. 70/Bu. u The contract’s “intrinsic” value is $. 20/Bu.

More Option Terminology: An options contract is said to be “out of the money” when it has no intrinsic value. n An options contract is said to be “at the money” when the strike price is equal to the current market price. n The “time value” is equal to the premium less the intrinsic value of the contract. n

“Out of the Money” Examples: n Call Option Example: (Long Position) u Dec corn futures price is $2. 20/Bu. u Dec corn call has a “strike price” of $2. 50/Bu. u The contract has no “intrinsic value. ” n Put Option Example: (Short Position) u Jul. corn futures price is $2. 70/Bu. u Jul. corn put has a “strike price” of $2. 50/Bu. u The contract has no “intrinsic value. ”

“At the Money” Examples: n Call Option Example: (Long Position) u Dec corn futures price is $2. 50/Bu. u Dec corn call has a “strike price” of $2. 50/Bu. u The contract has no “intrinsic value. ” n Put Option Example: (Short Position) u Jul. corn futures price is $2. 70/Bu. u Jul. corn put has a “strike price” of $2. 70/Bu. u The contract has no “intrinsic value. ”

Options Practice Problem: n Assume you pay a premium of $. 30/Bu. for a call with a strike price of $7. 00 and that the futures price at expiration is $7. 50. u What is the intrinsic value? u Is the call in the money, out of the money, or at the money? u What is the most you can lose on this contract? u What are my margin requirements?

Options Practice Problem 2: n Assume that May November futures for soybeans are at $8. 30/Bu. while the May November call option strike price is at $8. 50 at a cost of a $. 12 premium. u What is the intrinsic value of the contract? u What is the time value of the contract? u Why does the contract have time value? u What do you hope occurs?

What are my alternatives at the end an Options contract? n The option buyer obtains the right to exercise his chosen alternative by paying the premium to an option seller. n Exercise his option. (put) or (call) n Sell the option to someone else. n Let the option expire.

Option Basics: Premiums depend on market conditions such as volatility, time until an option expires, and economic variables. n The premium of an option is discovered through public out-cry in the CBOT pits. n Trading months for options are the same as those of the underlying futures contracts discussed in our futures unit of instruction. n

More Option Basics: As futures prices increase or decrease, additional higher and lower strike prices are listed. n Option strike prices can be found in daily newspapers, through on-line quotation services (DTN), internet, local grain elevators or brokers. n Commission fees are charged by brokers. n

Strike Price Basics: n Strike prices are listed in predetermined multiples for each commodity: u $. 25 per bushel for soybeans u $. 10 per bushel for corn u $. 10 per bushel for wheat u $. 10 per bushel for oats u $5. 00 per ton for SBOM below $200/ton u $10. 00 per ton for SBOM above $200/ton

Strike Price Basics Continued: The listed strike prices will include an ator near-the-money option, at least five strikes below and at least nine strikes above the at-the-money options. n This applies to both puts and calls. n The five lower strikes would follow normal commodity intervals. n

Strike Price Basics Continued: n The nine higher strikes would include five at normal intervals above the at-themoneys, plus an additional four strikes listed in even strikes that are double the normal intervals discussed previously.

Five Strategies for Buying and Selling Agricultural Options: Buying put options for protection against lower prices. n Buying put options for “price insurance” when you store your crop. n Writing call options to achieve a higher effective selling price for a crop you are storing. n

Five Strategies for Buying and Selling Agricultural Options: Buying call options at harvest to profit from a winter/spring price increase. n Buying call options for short-term protection against rising prices. n

Options offer “versatility: ” They can be used for protection against declining prices or against rising prices. n They can be used to achieve short-term objectives or long-term objectives. n They can be used conservatively or aggressively. n You hold the right to exercise your option when you feel it is the right time. n

Take Home Review Test: Free Breakfast at the June Meeting for the individual scoring the highest on the review test courtesy of JCH. n In case of tie, we will draw for the winner. n This format will be continued in the future to encourage you to review each meeting for your benefit. n

Next Month: n. Strategy Examples for Buying and Selling Agricultural Options.