Econ 339X, Spring 2011 ECON 339X: Agricultural Marketing Chad Hart Assistant Professor John Lawrence Professor

Econ 339X, Spring 2011 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 Corn Futures $5.76 per bushel Source: CBOT, 3/20/09 In-the-money Out-of-the-money

Econ 339X, Spring 2011 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 Sold Dec $5.76 Net = Cash Price + Futures Return

Econ 339X, Spring 2011 Put Option Graph Put Option Dec $5.80 Premium = $0.77 Net = Cash Price + Put Option Return

Econ 339X, Spring 2011 Put Option Graph Put Option Dec $5.80 Premium = $0.77

Econ 339X, Spring 2011 Out-of-the-Money Put Put Option Dec $4.50 Premium = $0.18

Econ 339X, Spring 2011 In-the-Money Put Put Option Dec $7.00 Premium = $1.61

Econ 339X, Spring 2011 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 Bought Dec $5.76 Net = Cash Price – Futures Return

Econ 339X, Spring 2011 Call Option Graph Call Option Dec $5.80 Premium = $0.73 Net = Cash Price – Call Option Return

Econ 339X, Spring 2011 Call Option Graph Call Option Dec $5.80 Premium = $0.73

Econ 339X, Spring 2011 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 Fence Buy Put Option Dec $5.50 Premium = $0.59 Sell Call Option Dec $6.50 Premium = $0.50

Econ 339X, Spring 2011 Spread Buy Put Option Dec $6.50 Premium = $1.23 Sell Put Option Dec $5.00 Premium = $0.35

Econ 339X, Spring 2011 Combination Strategies  Butterfly  Condor  Straddle  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: Spring2011/