1. Options

2. Semester Grade Options Grade Option Cost Today Only A$10 B$9 C$8 D$7 FFree

3. Semester Grade Options Grade Option Cost Today Only Price End of Semester A$10$100 B$9$90 C$8$80 D$7$70 FFreeFree

4. Semester Grade Options Grade Option Cost Today Only Price End of Semester Total Cost A$10$100$110 B$9$90$99 C$8$80$88 D$7$70$77 FFreeFreeFree

5. Options on Futures Separate market Option on the futures contract Can be bought or sold Price insurance Relatively new

6. Options on Futures Two types of options Four possible positions –Put BuyerSeller –Call BuyerSeller

7. Put option (Sell futures) 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.

8. Call option (Buy Futures) 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.

9. Options as price insurance Person wanting protection pays a premium If damage occurs the buyer is reimbursed for damages Seller keeps the premium but must pay for damages

10. Options May or may not have value at end –The right to sell at $2.20 has no value if the market is above $2.20 Can be offset, exercised, or left to expire Calls and puts are not opposite positions of the same market. They are different markets.

11. Strike price Level of price insurance Set by the exchange (CME, CBOT) A range of strike prices available for each contract

12. Premium Is traded in the option market –Buyers and sellers establish the premium through open out cry in the trading pit. Different premium –For puts and calls –For each contract month –For each strike price

14. Worksheet Land Option vs. Commodity Option –(File A2-66 & A2-67) http://www.extension.iastate.edu

15. Premium Depends on five variables 1.Strike price 2.Price of underlying futures contract The difference between 1. and 2. is called the “Intrinsic Value” 3.Volatility of underlying futures 4.Interest rate 5.Time to maturity 3, 4, & 5 make up what is called the “Time Value”

16. Premium relationship to: Strike price –Increases with the level of protection Futures volatility –Increases with riskiness of the contract

17. Premium relationship to: Time to maturity –Decreases the closer you get to contract expiration –Reflects carrying charge and risk Interest rates –Increases as rates increase

18. Premium relationship to: Underlying futures price –In-the-money –At-the-money –Out-of-the-money

19. In-the-money If expired today it has value Different for Call or Put –Put: futures price below strike price –Call: futures price above strike price

20. At-the-money If expired today it would breakeven Strike price nearest the futures price

21. Out-of-the-money If expired today it does not have value Different for Call or Put –Put: futures price above strike price –Call: futures price below strike price

22. Option buyer alternatives Let option expire –Typically when it has no value Exercise right –Take position in futures market –Buy or sell at strike price Re-sell option rights to another

23. Buyer decision depends upon Remaining value and costs of alternative Time mis-match –Most options contracts expire 2-3 weeks prior to futures expiration –Cash settlement expire with futures –Improve basis predictability

24. Option seller Obligated to honor option contract Can buy back option to offset position in order to get out of market

25. Worksheet: A2-66 Grain Price Options Basics (http://www.extension.iastate.edu/agdm/crops/ta/a2-66A2-67ta.doc)

26. Put option example (A farmer has corn to sell after harvest) 1) In May, buy a $2.80 Dec Corn Put Expected basis = -$0.25 Premium = $0.15 Commission = $0.01 Expected minimum price (EMP) = Strike Price (2.80) + Basis (-0.25) - Premium (0.15) - Commission (0.01) = $2.39

27. Put option example Lower 2) At harvest futures prices lower. Futures = $2.50 Cash market =$2.25 Option value = $2.80-2.50 =$0.30 Cash + Return – Cost = Net price 2.25 + 0.30 - 0.15 - 0.01 = $2.39

28. Put option example Higher 3) At harvest futures prices higher. Futures = $3.15 Cash market =$2.90 Option value = $0 Cash + Return – Cost = Net price $2.90 + 0 - 0.15 - 0.01 = $2.74

29. Call option example (A feedlot wants to buy corn to feed) 1) In May, buy a $3.00 Dec Corn Call Expected basis = -$0.25 Premium = $0.20 Commission = $0.01 Expected maximum price (EMP) = SP + Basis + Prem + Comm= $2.96

30. Call option example Lower 2) At harvest futures prices lower. Futures = $2.50 Cash market =$2.25 Option value = $0 Cash - Return + Cost = Net price $2.25 - 0 + 0.20 + 0.01 = $2.46

31. Call option example Higher 3) At harvest futures prices higher. Futures = $3.15 Cash market =$2.90 Option value = $3.15-3.00 =$0.15 Cash - Return + Cost = Net price $2.90 - 0.15 + 0.20 + 0.01 = $2.96

32. Net Price with Options Buy Put –Minimum price –Cash price - premium – commission Buy Call –Maximum price –Cash price + premium + commission

33. CME Manual page 75 Additional Exercise 1.You buy a June CME Live Cattle put option at a premium of $2.50/cwt. What is the total amount of the premium you pay for the put? 2.You buy a May corn call option at a premium of $0.25/bushel. What is the total premium you pay for the call? 3.You buy five August CME Feeder Cattle calls at $2.25/cwt. What is the total premium you pay for the calls?

34. CME Manual page 75 4.If the strike price of a corn put option is $3.00 and the futures price is at $2.65, what is the intrinsic value of the put? 5.If the strike price of a CME Feeder Cattle call option is $70.00 and the futures price is $68.50, what is the intrinsic value of the call? 6.You buy an October CME Live Cattle 86 put for a premium of $2.50/cwt. Later, you sell an October CME Live Cattle 86 put for a premium of $3.50/cwt. What is the gain or loss on the transaction?

35. CME Manual page 75 7.You buy a March CME Feeder Cattle 112 call for a premium of $3.00/cwt. Later, you sell a March CME Feeder Cattle 112 call for a premium of $1.50/cwt. What is the gain or loss on the transaction? 8.You bought a May corn 230 call for a premium of $0.16. Now the futures price is at $2.35. What will you do? a.Sell a May corn 230 call b.Buy a May corn 230 call c.Let the option expire

36. Worksheet: Short Hedge Feeder Cattle Buying Puts

37. Worksheet: Long Hedge Feeder Cattle Buying Calls

38. Worksheet: A2-67 Option Tools to Reduce Price Risk (http://www.extension.iastate.edu/agdm/crops/ta/a2-67ta.doc)

39. Futures Net Price Strike Price Long Cash Adjust for basis Hedge Adjust for basis Buy Put Hedger Position

40. Futures Net Price Strike Price Long Cash Adjust for basis Hedge Adjust for basis Buy Call Hedger Position

41. Options Workshop

42. Options are best when: Margin calls are a problem You’re not a selective hedger Feel markets are likely to favor you Likely to see major price moves

43. Hedging is best when: Fundamentals are bearish Markets are choppy Financing account no problem Understand selective hedging

44. CME Manual Page 88-89 1.You buy a May corn 300 put at a premium of $0.30/bushel. You expect the basis to be $0.15 under. What is your target selling price? 2.You buy a September CME Feeder Cattle 112 call at a premium of $2.75/cwt. You expect the basis to be $2.00 over. What is your target purchase price? 3.You buy a June CME Lean Hog 60 put at $1.75. You expect the basis to be $1.50 under. What is your target selling price?

45. CME Manual Page 88-89 4.You bought a wheat 380 put at a premium of $0.25/bushel. Now the futures price is $3.90. What will you do? a.Sell a 380 put b.Sell a 380 call c.Let the option expire 5.What is the formula for calculating the options gain or loss? a.Options selling price - options buying price b.Options buying price - options selling price 6.You bought July corn puts at a premium of $0.25/bushel and sold them back at a premium of $0.20/bushel. Then you sold the corn in the cash market at $2.80/bushel. What was the total price you received for your corn?

46. CME Manual Page 88-89 7.You bought July corn calls at a premium of $0.10/bushel and sold them back at a premium of $0.20/bushel. Then you bought the corn in the cash market at $2.65/bushel. What was the total price you paid for the corn? 8.You bought April Live Cattle 74 puts at a premium of $2.50/cwt. Now the 74 puts are worthless. You sell your cattle in the cash market for $78.50/cwt. What was the total price you received for the cattle? 9.You are planning to sell feeder cattle. Your target price is $75.00/cwt or more. You expect the basis to be $1.00 over. You can afford to spend $2,000 total premium. Which put should you buy? a.74 put at a premium of 82¢/cwt b.76 put at a premium of $2.02/cwt c.78 put at a premium of $3.82/cwt d.80 put at a premium of $5.77/cwt