ECON 337: Agricultural Marketing Chad Hart Associate Professor Lee Schulz Assistant Professor

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 $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.

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

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

Put Option Graph Dec Corn $ Strike $4.60 Premium = $ Net = Cash Price + Put Option Return

Short Hedge Graph Sold Dec Corn $ Net = Cash Price + Futures Return

Short Hedge Graph Sold Dec Corn $ Net = Cash Price + Futures Return

Comparison

Out-of-the-Money Put Dec Corn $ Strike $3.00 Premium = $0.005

In-the-Money Put Dec Corn $ Strike $6.00 Premium = $1.45

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

Call Option Graph Dec Corn $ Strike $4.60 Net = Cash Price – Call Option Return

Long Hedge Graph Bought Dec Corn $ Net = Cash Price – Futures Return

Comparison

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

Class web site: Spring2014/ Have a great weekend!