Introduction to Commodity Option Trading

McKinney, Texas

January 17, 2012

Commodity Options

• Options give the agricultural industry a flexible pricing tool to assist in price risk management.

– Offer a type of insurance against adverse price moves

– Require no margin deposits for buyers

– Allow buyers to participate in favor-able price moves.

• Commodity options are adaptable to a wide range of pricing situations.

– Agricultural producers can use commodity options to establish an approximate price floor, or ceiling, for their production or inputs.

Commodity options are tied directly to the

underlying futures.

Have their own contract specifications.

Commodity Options

• An option is simply the right, BUT NOT THE OBLIGATION, to buy or sell a futures contract at some predetermined price within a specified time period.

• In exchange for the right, the buyer makes an irrevocable payment (premium) to the seller of the option.

Commodity Options What is an Option?

For Producers, a Put Option is Like an Insurance Policy

Truck Insurance– You consider buying truck

insurance to protect against the RISK that the truck will have an accident.

– You decide on an appropriate DEDUCTIBLE.

– You pay a PREMIUM for your insurance.

Put Options– You consider buying a put to

protect against the RISK that prices will fall.

– You decide on an appropriate FLOOR PRICE.

– You pay a PREMIUM for a put.

Insurance Comparison (Cont.)Put Option

• In case of falling prices, the value of your put increases and you exercise or sell your put to collect this value from your broker as a GAIN.

Truck Insurance• In case of an accident,

you file a claim and collect an INDEMNITY

Insurance Comparison (Cont.)

Truck Insurance– You are pleased if you

don’t have an accident and the period covered by your insurance expires without a claim.

Put Option– You are pleased if

prices don’t fall (remain stable or rise) and your put expires with no value.

• Call Option - An option to buy a futures contract (go “long”).

• Put Option - An option to sell a futures contract (go “short”).

• Premium - the money an option buyer pays to an option writer for granting an option.

• Strike Price - The price at which the buyer of an option contract may choose to exercise the option.

Commodity Options Key Terms

Futures Market Position Options

Market

Sell = Short = Put

Buy = Long = Call

Put Option

Protects buyers from falling prices.

Call Option

Protects buyers from rising prices.

Commodity Options

Options Price Reporting July 2012 Wheat – Current Fut. Price = $6.45 ¾ /bu

Options Price Reporting Mar 2012 Corn – Current Fut. Price = $5.55 ¼ /bu

Options Price Reporting Apr 2012 FC – Curr. Fut. Price = $154/cwt

Options Price Reporting Oct 2012 LC – Curr. Fut. Price = $129.65/cwt

Commodity Options For Every Buyer, There is a Seller

Option Buyer

– Pays Premium

– Has the right to exercise the option.

– Goal: Price Protection

Option Seller

– Receives Premium

– Has obligation if option is exercised.

– Goal: Hope prices do not move causing the option to be exercised thus keeping the premium.

• Option sellers, unlike buyers, are exposed to potentially unlimited risk.– Option sellers expect the

market to move in such a way that the option will not be exercised, allowing the sellers to retain the full amount of the premium.

– However, option sellers are protected only in the amount of the option premium, should the market move against them.

• For this reason, sellers of options must have margin accounts, and will have to make margin calls whenever the market is moving against them.– Producers, therefore, should

consider very carefully before selling options as part of price risk management.

– Tax implications are not as clear if producers attempt to incorporate selling options.

Commodity Options Selling Options: Caution

Commodity Options Selling Options: Caution

Price

Premium

Seller losses all premium &difference between sold putstrike price + premium and

futures price.

Seller retains fullvalue of thepremium.

Seller loses part ofpremiumPremium

Sold Call + Premium

Sold Call Strike Price

• In-the-Money - A call option with a strike price lower, or a put option with a strike price higher, than the current market price of the underlying asset or futures contract.

• At-the-Money - An option whose strike price equals the current price of the underlying commodity, security, currency, index or futures contract.

• Out-of-the-Money -A call option with a strike price higher or a put option with a strike price lower than the current market price of the underlying commodity, security, currency, index or futures contract..

Commodity Options Key Terms

Commodity Options July 2012 Wheat – Current Fut. Price = 6.45 ¾ /bu

Price

July Futures Price Increases

Bought Put Strike Price

July Futures Price Falls

Option expires worthless

Option has value

Commodity Options Hedging Example - Wheat

Commodity Options Components of Option Premiums

Intrinsic Value & Time Value

• $7.50/bu July Wheat put option

• Current July Wheat Futures price = $6.45 ¾ /bu.

• The premium’s intrinsic value = $1.04 ¼ /bu.

• Here the option buyer could, theoretically, exercise the option, which would result in the delivery of a short futures position established at the strike price. The net result would be a short futures position established at $7.50 and offset at $6.45 ¾ for a gain of $1.04 ¼ which is also equal to the intrinsic value.

Commodity Options Intrinsic Value

The gross profit an option buyer could earn if the option was exercised.

• $7.50 wheat put option– Premium = $1.25 ½

• Current wheat futures price = $6.45 ¾

• Intrinsic Value = $7.50 - $6.45 ¾ = $1.04 ¼

• Time Value = $1.25 ½ - $1.04 ¼ = $0.21 ¼

For options with no intrinsic value, the entire premium

equals the time value.

Commodity Options Time Value

The option premium less the Intrinsic Value.In general, time value decreases as the amountof time remaining until expiration decreases.

Option premiums are determined by open outcry

in the trading pits of commodity exchanges.

Factors That Affect Option Premium Values

• Relationship between the underlying futures price and the option strike price.

• Length of time remaining until expiration

• Volatility of the underlying futures price.

• Interest rates.

Commodity Options Option Premium Values

Commodity Options Option Premium Values: Length of time

remaining until expiration.

• Ordinarily, the more time an option has until expiration, the higher its premium.– The option and underlying

futures has more time to fluctuate in value.

• Time increases the probability that the option will, at some point, move into the money and become profitable for the buyer.

• Therefore, an option’s time value will decline (erode) as the option approaches expiration.– This is why options are

sometimes described as “eroding or time decaying assets.”

• Generally, option premiums are higher during periods of volatile futures prices.

– The increased price risk associated with a volatile market results in the cost of obtaining the insurance through options to be greater.

• An option is more likely to move into the money and be profitable for the buyer when prices are volatile.

• Sellers (attempting to avoid losses) require higher premiums.

• It is possible that an option 3 months from expiration to command a higher premium in a volatile market than an option 4 months from expiration in a stable market.

Commodity Options Option Premium Values: Volatility of the

underlying futures price.

• If an option is Out-of-the- Money or At-the-Money at the time when the option expires, the option expires worthless

– The option buyer is out only the premium paid for the option.

– The option seller keeps the option premium that was received for selling the option.

• If an option has value (is In- the-Money), you have two ways to obtain the profits made.

– Exercise the option

– Offset the option

Commodity Options Completing the Option Trade

Exercising an option

• Taking the actual futures position.

– The buyer of a put option can exercise that option and have a short position in the futures market at the strike price.

– Can be exercised at any time before the expiration of the contract.

Offsetting the option

• Canceling an option position by initiating an opposite transaction on the option trading exchange.– Selling or buying an equal

number of put or call options at the same strike price for the same month.

– Can be offset at any time before the expiration of the contract.

Commodity Options How to Get Money out of an Option

• If an option strike price is Out- of-the-Money, there still may be some time value to an offset premium on an unexpired contract.

• If the option strike price is In- the-Money, the intrinsic value is equal to the value of an exercised position on the futures market plus any remaining time value. Given this time value, returns from the offset are greater than returns from exercising.

• You may be charged additional brokerage fees for exercising an option (check with your broker).

Commodity Options Why Offset vs. Exercise an Option

Commodity Options Hedging with a Put Example

• Rick is a wheat farmer who harvests in late June. His 10 year average wheat production on his farm is 37,000 bushels. In the past five years, his lowest production has been 23,000 bushels. (Current July Futures = 6.45 ¾)

• In Jan: July CME Wheat $6.50 put = $6.50 / buHistorical harvest time basis = - $0.85 / buJuly $6.50 put premium = - $0.56 3/8 / bu.Mike projects a harvest net price of $ 5.08 5/8 /bu

• Rick buys enough puts to hedge 25,000 bushels (or 5 puts)

Projected at -$0.85/bu at

harvest

Buys 5 July CME Wheat puts

at $6.50 strike

Objective: Realize a wheat sales price of at

least $5.08 5/8 /bu

Jan

BasisOptions MarketCash Market

• In June: July CME Wheat Futures = $5.00 /buActual harvest time basis = -$0.85/buCash price = $4.15 /buGross value of put ($6.50-$5.00) = +$1.50/buGross realized price = $5.65/buPut premium = -$0.56 3/8 /buNet realized price = $5.08 5/8 /bu

Commodity Options Hedging with a Put Example – Price Decrease

• In June: July COBT Wheat Futures = $8.50 /buActual harvest time basis = -$0.85/buCash price = $7.65 /buGross value of put = +$0.00/buGross realized price = $7.65/buPut premium = -$0.56 3/8 /buNet realized price = $7.08 5/8 /bu

Commodity Options Hedging with a Put Example – Price Increase

Commodity Options Hedging with a Call Example

• Rick is also a dairy producer who would like to protect his corn feed cost next spring by buying a call. He uses about 200,000 pounds of corn per month and would like to hedge enough corn to cover both March and April (400,000 pounds or 7,142 bu). (Current May futures price = $6.06 ½ /bu)

• Jan: May CME Corn 6.00 call = $6.00 / buHistorical March corn basis = - $0.50 / buMay $6.00 call premium = + $0.41 3/8 / bu.Mike projects a net purchase price of $ 5.91 3/8 /bu

• Rick buys enough calls to hedge 7,000 bushels (or 1 call)

Projected at -$0.50/bu

Buys 1 May CME Corn call at $6.00 strike

Objective: secure a corn purchase price of at most

$5.91 3/8 /bu

Jan

BasisOptions MarketCash Market

• March: May CME Corn Futures = $8.00/buActual basis = -$0.50/buCash price = $7.50/buGross value of call ($8.00-$6.00) = - $2.00/buGross realized price = $5.50/buCall premium = +$0.41 3/8 /buNet realized price = $5.91 3/8 /bu

Commodity Options Hedging with a Call Example

Current Option Contracts

• What prices can we lock-in currently given the current market?

Wheat July 2012 Harvest

Current July 2012 Wheat Futures Price = $6.45 ¾ /buBasis = $0.85 under futures

Strike Price Premium Basis Projected Net Price

In the Money Put $7.00 - $0.88 - $0.85 = $5.27

At the Money Put $6.50 - $0.56 3/8 - $0.85 = $5.08 5/8

Out of the Money Put

$6.00 - $0.32 1/8 - $0.85 = $4.82 7/8

Corn December 2012 Harvest

Current December 2012 Corn Futures Price = $5.55 ¼ /buBasis = $0.48 under futures

Strike Price Premium Basis Projected Net Price

In the Money Put $6.10 - $0.92 5/8 - $0.48 = $4.69 3/8

At the Money Put $5.60 - $0.61 - $0.48 = $4.51

Out of the Money Put

$5.10 - $0.36 - $0.48 = $4.26

• Flexible price insurance with a limit to the financial obligation.

• When viewed as price insurance, option costs can be added to other production and marketing costs in determining a price objective.

• Producers have the potential to take advantage of favorable price movements while being protected against unfavorable ones.

• There is limited financial obligation because of the one- time fee plus brokerage fee.

Commodity Options Reason to Consider Options

Commodity Options

• I have developed an Excel program that will help you in calculating the estimated floor/ceiling price you can set using commodity options.– You can download this software free of charge– There is a User’s Manual that you can also download.

http://dallas.tamu.edu/econ/Software/Put%20Option%20Analyzer.html