Econ 337, Spring 2012 ECON 337: Agricultural Marketing Chad Hart Assistant Professor

Econ 337, Spring 2012 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 337, Spring 2012 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 337, Spring 2012 Put Option Graph Put Option Nov $11.80 Premium = $0.89 Commission = $0.01 Strike Price = $11.80 Put Option Return = Max(0, Strike Price – Futures Price) – Premium – Commission

Econ 337, Spring 2012 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 337, Spring 2012 Call Option Graph Call Option Nov $11.80 Premium = $0.93 Commission = $0.01 Strike Price = $11.80 Call Option Return = Max(0, Futures Price – Strike Price) – Premium – Commission

Econ 337, Spring 2012 Option Premiums  Can be divided into two sections:  Intrinsic value  What is the option worth today?  Time value  How much time is left on the option? Intrinsic value depends on the futures price and the strike price of the option. Time value depends on the length of time in the option and the price volatility in the market.

Econ 337, Spring 2012 Example DayFutures Price Option Premium Intrinsic Value Time Value 1$12.00$0.60$0.00$0.60 2$12.20$0.56$0.00$0.56 3$11.70$0.83$0.30$0.53 4$11.55$0.95$0.45$0.50 5$11.90$0.67$0.10$0.57 Start with an soy put $12.00 per bushel

Econ 337, Spring 2012 Combination Strategies  Option fence  Buy put and sell call  Put spread  Buy At-the-money put and sell Out-of-the- money put

Econ 337, Spring 2012 Option Returns in Fence Buy Put Option Nov $11.80 Premium = $0.89 Sell Call Option Nov $12.80 Premium = $0.58

Econ 337, Spring 2012 Fence for Speculator Buy Put Option Nov $11.80 Premium = $0.89 Sell Call Option Nov $12.80 Premium = $0.58

Econ 337, Spring 2012 Fence for Hedger Buy Put Option Nov $11.80 Premium = $0.89 Sell Call Option Nov $12.80 Premium = $0.58

Econ 337, Spring 2012 Option Returns in Spread Buy Put Option Nov $11.80 Premium = $0.89 Sell Put Option Nov $10.00 Premium = $0.22

Econ 337, Spring 2012 Spread for Speculator Buy Put Option Nov $11.80 Premium = $0.89 Sell Put Option Nov $10.00 Premium = $0.22

Econ 337, Spring 2012 Spread for Hedger Buy Put Option Nov $11.80 Premium = $0.89 Sell Put Option Nov $10.00 Premium = $0.22

Econ 337, Spring 2012 Combination Strategies  Butterfly  Condor  Straddle  Strangle  These positions can be flipped

Econ 337, Spring 2012 Condor Buy $11.00 Premium = $0.51 Sell $10.00 Premium = $0.22 Buy $12.00 Premium = $0.52 Sell $13.00 Premium = $0.85

Econ 337, Spring 2012 Condor for Hedger

Econ 337, Spring 2012 Condor for Hedger

Econ 337, Spring 2012 Class web site: Spring2012/ Lab in Heady 68