1. Grain Marketing in the BioFuels Era: Session 2: Options Strategies: January 29 Ethanol

2. For more information about reading charts, see CMS Disk 2, Unit 6 on Technical Analysis

5. Introduction to Options (CMS Disk 1, Unit 2, modules 6a and 6b)

6. Objectives Become familiar with options terminology Understand the advantages and disadvantages of options Recognize when it is profitable to exercise an option.

7. What is an Option? right obligation,Definition: An option is the right, but not the obligation, to buy or sell a futures contract at some predetermined price at anytime within a specified time period. Options are derivative instruments. The option is written on an underlying asset— the futures contract.

8. Calls and Puts call optionA call option is the right to buy the underlying futures contract at a predetermined price prior to expiration. put optionA put option is the right to sell an underlying futures contract at a predetermined price prior to expiration.

9. Strike Price and Premium strike price exercise priceThe predetermined price at which an underlying futures contract may be bought or sold is called the strike price or the exercise price. premiumThe premium is the amount paid for an option. (Paid up-front, no matter what).

10. An Option Example December Corn $2.30 Call Underlying Asset Strike Price Option Type

11. Strike Price Listing then a predetermined number of strikes above and below When an option is first listed, the strike prices include the closest strike to a futures price and then a predetermined number of strikes above and below. The number of strikes will vary by exchange. As market conditions change, additional strikes are listed.

12. Options – CBOT Example (Jan 19, 2007) Corn cents/bu Futures = 390 ¾ CallPut Strike PriceDec07 3704929 3/8 38045 3/835 39041 7/841 ¼ 40038 7/847 5/8 41035 7/8-- 4203361 ¼

13. Premiums Premiums Premiums are determined in an open outcry auction. It’s important to realize that all of the options terms are set by the exchange except for the premium. The premium is paid up-front by the buyer and must be paid whether the option is exercised or not.

14. Option Alternatives The buyer of the option may do the following prior to the option expiration: –exercise the option (get the futures position) –offset or liquidate the position Buy a put ---sell same put Buy a call---sell same call –allow the option to expire. No obligation with an option purchase!

15. When Is an Option Exercised? Options can be exercised if profitable. –a put option is profitable when the option strike is above the underlying futures price (the right to sell higher than the current futures price) –a call option is profitable when the strike price is below the underlying futures price (the right to buyer below the current market)

16. What About the Sellers of Options? Option Seller (Writer): –receives the premium from the option buyer, and –must take the opposite position if the option is exercised. As a result, – the option seller must post margin, and –may face margin calls.

17. Option Jargon In-the-moneyIn-the-money: An option is said to be in-the- money if it is profitable to exercise. Out-of-the-moneyOut-of-the-money: An option is said to be out-of- the-money if a loss would result if it were exercised. At-the-moneyAt-the-money: An option is at-the-money if its strike price is the same as its underlying futures price.

18. Valuing Options in the BioFuels Era

19. What Determines an Options Value? 1.Intrinsic Value: the positive value if an option were to be exercised –Put: Strike Price is Above the Current Futures –Call: Strike price is below the current Futures 2. Days to Expiration -Value increases as time to expiration increases

20. What Determines an Options Value? 3.Volatility of Underlying Futures Higher volatility increases option premiums 4.Interest Rates Higher interest rates lower option premiums

21. BioFuels Era Impact on Options Value With the increase in biofuels demand for corn and uncertainty about supply, volatility of futures has increased! –Average volatility from 1980-2006: 18.3% –Average volatility in 2005: 21.9% –Average volatility in 2006: 28.8% This makes option premiums greater than when prices were lower and less volatile

22. Biofuels Era Impact on Options Value (%)

23. Hedging with Options (CMS Disk 1, Unit 2, module 7)

24. Objectives Understand the mechanics of hedging with options Establish the advantages and disadvantages of options hedges Complete examples of options hedges

25. Hedging with Options A long cash market position can be hedged with options to provide a minimum (floor) price, but also enable higher prices if subsequent futures prices were to rise ( a floor price but no ceiling). Two common strategies: –Buy a put option –Sell cash grain and buy an OTM call option “Sell and defend” Both strategies set a price floor price and also allow you to gain if futures prices subsequently increase.

26. Why Options Over Futures? Seller’s/Buyer’s RemorseSeller’s/Buyer’s Remorse: Option hedgers can take advantage of favorable price movements. Posting and Managing MarginPosting and Managing Margin: Buyers of options do not post margin (although writers do).

27. Which Month and Strike for You to Buy? 1. Contract Month Time Frame of the Objective 2. Cost of premium 3. Protection level: What is the tradeoff between the premium and the protection? -Lower protection---lower costs -Higher protection---higher costs 4. Outlook – what is likely to happen to the underlying futures price. -----------Plus some more---------

28. Also for you to consider 5. Your risk bearing ability 6. Your costs of production 7. Your pricing objectives 8. Your understanding of pricing alternatives

29. A Soybean Example … It’s late Spring and you want to protect against low soybean prices at harvest. What month? What option type? Which strike do you select? November futures: $5.75 Put option @ $5.75: 25 cents Put option @ $5.50: 15 cents

30. Buy a Put (Strategy #2, p50) Goal: Establish a price floor Advantage: Establishes a floor price but not a ceiling Disadvantage: Premium cost

31. Example—Buy a Put In May, an Indiana corn producer seeks to protect the value of corn sold at harvest. Question: What type of option should this producer consider buying? Why? What month? Question: What are the advantages of this option hedge over futures hedging?

32. Example—Buy a Put Current Dec07 Futures @ $3.90/bu. Premium for $3.80 put is $0.35/bu. Expected Basis is $0.20 under. What minimum price is established?

33. Example—Buy a Put Min. Price = $3.80 - $0.35 - $0.20- $0.02 = 3.23 Minimum Price = Strike Price - Premium - Expected Basis - Hedging Costs (Interest/Brokerage Fee)

34. Example--Put, Prices Fall At marketing in November, suppose prices fall. Futures Prices @ $3.00 Cash Prices @ $2.80 What is the net price received ? Net Price = Futures Price +(-) Basis - Premium - Hedging Costs + Options Gain

35. Net Price = $3.00 (Futures Price) - 0.20 (Basis) -0.35 (premium) -0.02 +0.80 (Options Gain:$3.80-3.00 ) $3.23 Net Price per bushel Example--Put, Prices Fall Cash Price The Minimum Price! Net Price = Futures Price +(-) Basis - Premium - Hedging Costs + Options Gain (Strike-Futures)

36. Example--Put,Prices Increase Slightly Net Price = $4.00 (Futures Price) -0.20 (Basis) -0.35 (premium) -0.02 (hedging) costs 0 +0 (Options Gain:$3.80-4.00=0 ) $3.43 Net Price per cwt Net Price = Futures Price +(-) Basis - Premium - Hedging Costs + Options Gain

37. Example--Put, Price Increase! Yahoo! Net Price = $4.40 (Futures Price) -0.20 (Basis) -0.35 (premium) -0.02 (hedging costs) 0.00 +0.00 (Options Gain) $3.83 Net Price per cwt Above the Minimum Price! Net Price = Futures Price +(-) Basis - Premium - Hedging Costs + Options Gain

38. Buy a Put Example Summary Price Floor Upside Potential Buying a put establishes a minimum price Strike: $3.80 Premium: $0.35Basis: -$0.20 FuturesCashBuy $3.80 Put 3.403.203.23 3.603.403.23 3.803.603.23 4.003.803.43 4.204.003.63 4.404.203.83 4.604.404.03

39. Buy a Put Strike Price Tradeoff You have a choice of different strike prices Assume basis is.20 under and hedging costs of 2 cents $3.50 Dec07 corn put costs $0.18 $3.90 Dec07 corn put costs $0.38 $4.40 Dec07 corn put costs $0.71

40. FuturesCashBuy $3.50 PutBuy $3.90 PutBuy $4.40 Put $3.10$2.90$3.10 $3.30$3.47 $3.30$3.10 $3.30$3.47 $3.50$3.30$3.10 $3.30$3.47 $3.70$3.50$3.30 $3.47 $3.90$3.70$3.50 $3.30$3.47 $4.10$3.90$3.70 $3.50$3.47 $4.30$4.10$3.90 $3.70$3.47 $4.50$4.30$4.10 $3.90$3.57 $4.70$4.50$4.30 $4.10$3.77 $4.90$4.70$4.50 $4.30$3.97 $5.10$4.90$4.70 $4.50$4.17 $5.30$5.10$4.90 $4.70$4.37 $5.50$5.30$5.10 $4.90$4.57

41. Strike Price/Premium Tradeoff Put: –Higher strike price means more price protection, but it costs more –Lower strike price costs less, but it means less price protection Call: –Lower strike price means more chance of payoff, but it costs more –Higher strike price costs less, but means less chance of payoff (futures price has to increase more to get above the strike price)

42. Sell Cash and Buy OTM Call (Strategy #5, p. 57) Strategy is called a synthetic put because it establishes a price floor and leaves upside potential in place (no ceiling) –Pre-harvest combine a forward contract with OTM call –Post-harvest combine cash sale with OTM call

43. Example—Sell Cash Grain in March and Buy OTM Call (Weather Protection) Current July07 Futures on March 1 are $4.25/bu. Cash price on March 1 is $4.00. Corn delivered and sold at $4.00. Premium for $4.50 July call is $0.28 –A $4.50 call is OTM—this option allows the owner to gain if July futures move above $4.50. Since the current July futures is $4.25, they cannot start gaining until the July futures move up $.25 per bushel. (They can gain after the market moves up $.25/bu.) What minimum price is established?

44. Example—Sell Cash Grain, Buy OTM Call Min. Price = $4.00 - $0.28- $0.02 = $3.70/bushel Minimum Price = Cash Price - Premium - Hedging Costs (Interest/Brokerage Fee)

45. Example—Cash & Call, Prices Fall Say by June weather has favorable and July futures drop. July Futures Prices @ $3.25 What is the net price received ? Net Price = Cash Price - Premium - Hedging Costs + Options Gain

46. Net Price = $4.00 (Cash Price) -0.28 (premium) -0.02 +0 (no gain on options) $3.70 Net Price per bu Example—Cash & Call, Prices Fall The Minimum Price! Net Price = Cash Price - Premium - Hedging Costs + Options Gain

47. Example—Cash & Call, Futures Price Increases Slightly (from $4.25 to $4.50) Net Price = $4.00 (Cash Price) -0.28 (premium) -0.02 (hedging) costs 0 +0 (Options Gain) $3.70 Net Price per cwt The Minimum Price! Net Price = Cash Price - Premium - Hedging Costs + Options Gain

48. Example—Cash & Call, Futures Price Increases (from to $5.00) Yahoo! Net Price = $4.00 (Cash Price) -0.28 (premium) -0.02 (hedging costs) +0.50 (Options Gain: $5.00-$4.50) $4.20 Net Price per bu Above the Minimum Price! Net Price = Cash Price - Premium - Hedging Costs + Options Gain

49. Price Floor Upside Potential Selling $4.00 Cash and buying a $4.50 Call (Minimum cash price, with chance to gain if futures move above $4.50). Call Strike: $4.50 Premium: $0.28Basis: $0.00 FuturesCashSell 4.00 Cash & Buy $4.50 Call 3.80 3.70 4.00 3.70 4.20 3.70 4.40 3.70 4.60 3.80 4.80 4.00 5.00 4.20

50. Sell a Call (Strategy #3, p. 52) Goal: Increase selling price Advantage: Receive premium Disadvantage: Little price protection and sets maximum price (price ceiling)

51. Sell a Call Current Dec07 Futures @ $3.90/bu. Premium for $4.00 call is $0.36/bu. Expected Basis is $0.20 under. What maximum price is established?

52. Example—Sell a Call Max. Price = $4.00 + $0.36 - $0.20- $0.02 = 4.14 Maximum Price = Strike Price + Premium - Expected Basis - Hedging Costs (Interest/Brokerage Fee)

53. Example—Sell Call, Prices Fall At marketing in November, suppose prices fall. Futures Prices @ $3.00 Cash Prices @ $2.80 What is the net price received ? Net Price = Futures Price +(-) Basis + Premium - Hedging Costs - Options Loss

54. Net Price = $3.00 (Futures Price) - 0.20 (Basis) +0.36 (premium) -0.02 +0 (Options Loss:$3.00-4.00 ) $3.14 Net Price per bushel Example—Sell Call, Prices Fall Cash Price Net Price = Futures Price +(-) Basis + Premium - Hedging Costs - Options Loss (Futures-Strike)

55. Example—Sell Call,Prices Increase Slightly Net Price = $4.20 (Futures Price) -0.20 (Basis) +0.36 (premium) -0.02 (hedging) costs -.20 (Options Loss:$4.00-4.20=-.20 ) $4.14 Net Price per cwt Net Price = Futures Price +(-) Basis + Premium - Hedging Costs - Options Loss The Maximum Price

56. Example—Sell Call, Price Increase Net Price = $4.60 (Futures Price) -0.20 (Basis) +0.36 (premium) -0.02 (hedging costs) 0.60 -0.60 (Options Loss) $4.14 Net Price per cwt Still Maximum Price Net Price = Futures Price +(-) Basis + Premium - Hedging Costs - Options Loss

57. Sell a Call Example Summary Price Ceiling Selling a call establishes a maximum price Strike: $4.00 Premium: $0.36Basis: -$0.20 FuturesCashSell $4 Call 3.403.203.54 3.603.403.74 3.803.603.94 4.003.804.14 4.204.004.14 4.404.204.14 4.604.404.14 Limited downside protection

58. Fence (Window): Buy a Put and Sell a Call (Strategy #4, p. 53) Goal: Provides both floor price and ceiling price. Locks in cheap price protection Advantage: Cost of floor price protection (put) is reduced by income from selling call Disadvantage: Limited upward price potential (establishes a ceiling price)

59. Fence (Window) : Buy a Put and Sell a Call Combine previous two strategies with OTM Put and OTM Call Current Dec07 Futures @ $3.90/bu. –Premium for $4.20 call is $0.30/bu. –Premium for $3.60 put is $0.26/bu. Expected Basis is $0.20 under What minimum and maximum prices are established?

60. Fence or Window Total premiums = -$0.26+$0.30 = +$0.04 Buy Put establishes minimum price (price floor) Min Price = Put Strike Price + Total Premium- Expected Basis - Hedging Costs Minimum price=3.60+0.04-0.20-0.04=3.40 Sell Call establishes maximum price (price ceiling) Max Price = Call Strike Price + Total Premium- Expected Basis - Hedging Costs Maximum price = 4.20+0.04-0.20-0.04 = 4.00

61. Fence Example Summary Price Floor Price Ceiling Buy $3.60 Put for $0.26 per bushel Sell $4.20 Call for $0.30 per bushel with a Basis = -$0.20 FuturesCashFence: Buy $3.60 Put & Sell 4.20 Call 3.403.203.40 3.603.40 3.803.60 4.003.80 4.204.00 4.404.204.00 4.604.404.00 Open window

62. Before Hedging with Options… Calculate minimum price –Is this price above loan? An LDP is a free put—no need to buy another Is this price high enough to cover your costs? Is the option strategy the best alternative given all the pricing alternatives and your farm’s individual considerations?

63. Pricing Options Summary 1. Do no forward pricing 2. Futures Hedge (lock in the futures price) 3. Options Hedges –Long cash grain and buy Puts (floor price, no ceiling) –Sell cash grain and buy OTM Calls (floor price, no ceiling) (called a synthetic put) –Long cash grain and sell Calls (Ceiling price, limited downside protection) –Long cash grain and Fence by buying Puts and selling Calls (establishes a floor and ceiling price at a low costs)

64. Readings for Feb 5 th: Cash Markets In “Understanding Basis” –p. 1-12 (read more if interested) Under “Pricing Strategies” you’ll find “Offering Farmers Cash Contracts” –p. 4-11 and p. 16-20 –If your photocopy is too dark, you can read this document on the course website: www.agecon.purdue.edu/extension/programs/ grain_marketing.asp

65. Assignments 1.Options exercise completed 2.For the options strike prices you are interested in, watch how the premium changes each day as the underlying futures contract changes How does the minimum price change with changes in the premium?

66. Questions To email in questions, either give them to your host or send them to Corinne Alexander: cealexan@purdue.edu