Agricultural Marketing ECON 337: Agricultural Marketing Chad Hart Assistant Professor chart@iastate.edu 515-294-9911 1

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.

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.

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.

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.

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.

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.

Option Issues and Choices The option may or may not have value at the end The right to buy corn futures at $4.00 per bushel 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.

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

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

Option References In-the-money At-the-money Out-of-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

Options Premiums Mar. 2012 Soy Futures $11.87 per bushel In-the-money Out-of-the-money 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

Put Option Graph Put Option Nov. 2012 Soybean @ $11.80 Strike Price = $11.80 Put Option Return = Max(0, Strike Price – Futures Price) – Premium – Commission Premium = $0.89 Commission = $0.01

Put Option Graph Put Option Nov. 2012 Soybean @ $11.80 Premium = $0.89 Net = Cash Price + Put Option Return

Short Hedge Graph Sold Nov. 2012 Soy Corn @ $11.83 Net = Cash Price + Futures Return

Comparison

Out-of-the-Money Put Put Option Nov. 2012 Soy @ $10.80 Premium = $0.44

In-the-Money Put Put Option Nov. 2012 Soy @ $12.80 Premium = $1.53

Comparison

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

Call Option Graph Call Option Nov. 2012 Soybean @ $11.80 Strike Price = $11.80 Call Option Return = Max(0, Futures Price – Strike Price) – Premium – Commission Premium = $0.93 Commission = $0.01

Call Option Graph Call Option Nov. 2012 Soy Corn @ $11.80 Premium = $0.93 Net = Cash Price – Call Option Return

Long Hedge Graph Bought Nov. 2012 Soy @ $11.83 Net = Cash Price – Futures Return

Comparison

Summary on Options Buyer Seller Buying puts Buying calls 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/Spring2012/ Have a great weekend!