1. ECON 337: Agricultural Marketing Chad Hart Associate Professor chart@iastate.edu 515-294-9911 Lee Schulz Assistant Professor lschulz@iastate.edu 515-294-3356

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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

10. 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

11. 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

12. Options Premiums Dec. 2014 Corn Futures $4.60 per bu. Source: CME, 2/5/13 In-the-money Out-of-the-money

13. 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

14. Put Option Graph Dec. 2014 Corn Futures @ $4.5925 Premium = $0.36125 Commission = $0.01 Strike Price @ $4.60 Put Option Return = Max(0, Strike Price – Futures Price) – Premium – Commission

15. Put Option Graph Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $4.60 Premium = $0.36125 Net = Cash Price + Put Option Return

16. Short Hedge Graph Sold Dec. 2014 Corn Futures @ $4.5925 Net = Cash Price + Futures Return

17. Short Hedge Graph Sold Dec. 2014 Corn Futures @ $4.5925 Net = Cash Price + Futures Return

18. Comparison

19. Out-of-the-Money Put Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $3.00 Premium = $0.005

20. In-the-Money Put Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $6.00 Premium = $1.45

21. Comparison

22. 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

23. Call Option Graph Dec. 2014 Corn Futures @ $4.5925 Premium = $0.35375 Commission = $0.01 Strike Price @ $4.60 Call Option Return = Max(0, Futures Price – Strike Price) – Premium – Commission

24. Call Option Graph Dec. 2014 Corn Futures @ $4.5925 Strike Price @ $4.60 Net = Cash Price – Call Option Return

25. Long Hedge Graph Bought Dec. 2014 Corn Futures @ $4.5925 Net = Cash Price – Futures Return

26. Comparison

27. 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

28. Class web site: http://www.econ.iastate.edu/~chart/Classes/econ337/ Spring2014/ Have a great weekend!