1 agricultural commodity options options grants the right, but not the obligation,to buy or sell a...
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Agricultural Commodity Options
Options grants the right, but not the obligation,to buy or sell a futures contract at a predetermined price for a specifiedperiod of time.
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OPTIONS TERMS
Strike Price: The predetermined price of the futures contract i.e. price at which the futures contract can be bought or sold.
Premium: The cost of the right to buy or sell a futures contract – cost of the option. The buyer loses the premium regardless of whether the option is used or not.
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Real Estate ExampleSuppose that on June 1, a farmer is approached by his neighbor
about purchasing 100 acres of adjacent land at $1,600 per acre. The farmer is almost certain that he wants the land but is unable to arrange financing for six months. The neighbor proposes to grant a six-month option on the property at $1,600 per acre in exchange for a $12 per acre fee ($1,200). This option is similar to a commodity option with the following characteristics:
Purchaser = The farmer (Option buyer)
Grantor = The neighbor (Option seller)
Exercise price = $1,600 (Strike price)
Expiration date = December 1
Premium = $1,200
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Options are popular because:
1) Price Insurance.
2) Limited financial obligation.
3) Marketing flexibility.
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Two Types of Options
• PUT OPTION
Gives buyer right to sell underlying futures contract.
• CALL OPTION
Gives buyer right to buy underlying futures contract.
– In both cases the underlying commodity is a futures contract, not the physical commodity
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PUT OPTION
A put option gives the holder the right, but not the obligation, to sell a specific futures contract at a specific
price
“To put it on them”
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Call Option
A call option gives the holder the right, but not the obligation, to buy a
specific futures contract at a specific price
“To call from them”
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Put and Call Options
• Put Option:– The right to sell a futures contract– Provides protection against falling prices– Sets a minimum price target
• Call Option:– The right to buy a futures contract– Protects against rising prices (e.g. feed
costs)– Allows participation in seasonal price rises
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How Is the Premium ForAn Option Determined?
Question: What would you be willing to pay forthe right to sell a futures contract at $3.00 if thecurrent futures price is $2.80?
Answer: If the premium is under $.20, youcould make a profit by exercising theoption (sell @ $3) and buy a futures contract for $2.80 at the same time, making a $20profit.
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Factors Affecting Option Premiums
• Difference between the strike price of the option and the price of the underlying commodity (futures contract)– INTRINSIC VALUE
• Length of time to option expiration– TIME VALUE
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Components of Premium
• Intrinsic Value
+
• Time Value
=
Premium
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INTRINSIC VALUE
“positive” difference between the strike price and the underlying commodity futures price
FOR A PUT OPTION – strike price exceeds futures price
FOR A CALL OPTION – strike price below futures price
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TIME VALUE
• Portion of option premium resulting from length of time to expiration. Expiration is the date on which the rights of the option holder expire.
• Usually decreases with length of time until expiration, but does increase as price volatility of the underlying futures contract increases.
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Components of Time Value
• Time
• Volatility
• Interest rates
• Underlying futures price
• Strike price
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Time Decay
0
0.25
0.50
0180 90Days to expiration
Time value
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Options are said to be:
In the money (ITM) – have intrinsic value
Out of the money (OTM) – have no intrinsic value
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Call Option
In-the-Money (ITM)Strike price < Futures price
At-the-Money (ATM)Strike price = Futures price
Out-of-the-Money (OTM)Strike price > Futures price
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Payoff diagram – Long Call
$0.50
$1.00
0
$1.00
$0.50
Profit
Loss
$7.50$7.00$6.50 $8.50$8.00
OTM ITMATM
Buy Call
@$.50/Bu
Beans Price at Expiration
Strike Price
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Put Option
In-the-Money (ITM)Strike price > Futures price
At-the-Money (ATM)Strike price = Futures price
Out-of-the-Money (OTM)Strike price < Futures price
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Payoff diagram – Long Put
$0.25
$0.50
0
$0.50
$0.25
Profit
Loss
$7.50$7.25$7.00 $8.00$7.75
ITM OTMATM
Buy Put
@$.25/Bu
Beans Price at Expiration
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What Happens to An OptionWhich You Own?
• It Can Expire– Unexercised Options Die – You Must Still Pay the Option Premium
• You can Exercise the Option– Put: Sell the Futures Contract– Call: Buy the Futures Contract
• Offsett, By Selling the Put or Call Option
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Reasons Why a Producer Might Buy Options
Action Reason
Buys a Put
Buys a Call
Buys a Call
Needs price protection (floor) for crops.
Needs price protection (ceiling) on feed requirements.
Has sold crops and believes prices are going to rise.
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OPTIONS WORKSHEET
STRIKE PRICE ___________
- EXPECTED BASIS ___________
- PREMIUM ___________
- COMMISSION ___________
= EXPECTED MIN NET
SELLING PRICE ___________
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Put Option Example
Date Cash Futures Option Market Market Market
Spring Sell Dec. @$4 Buy Dec Put Strike=$4 Premium=$.20
Harvest $2.50 Dec. Fut=$3 Sell Dec Put Sell Dec@$4 Strike=$4 Buy Dec@$3 Premium=$1.20
GAIN……………………..$1………………$1
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Pricing Alternatives(Falling Market)
Date Cash Sale Forward PreHarvest Option At Harvest Contract Hedge ($.20 prem.)
Spring $3.40 Sell Dec Buy PutPlanting offer @$4 $4 strike
Fall [email protected] Deliver Buy Dec Sell Dec@$4Harvest @$3.40 @$3 Buy Dec@$3
Net Return $2.50 $3.40 $2.50 cash $2.50 cash +$1 fut.=$3.50 +$1 fut-.20=$3.30
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Pricing Alternatives(Rising Market)
Date Cash Sale Forward Pre-Harvest Option At Harvest Contract Hedge ($.20 prem.)
Spring $3.40 Sell Dec Buy PutPlanting offer @$4 $4 strike
Fall [email protected] Deliver Buy Dec Let OptionHarvest @$3.40 @$5 Lapse/Die
Net Return $4.50 $3.40 $4.50 cash $4.50 cash -$1 fut.=$3.50 -.20=$4.30