1 Agricultural Commodity Options Options grants the right, but not the obligation,to buy or sell a futures contract at a predetermined price for a specified period of time.

2 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.

3 Real Estate Example Suppose 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

4 Options are popular because: 1)Price Insurance. 2)Limited financial obligation. 3)Marketing flexibility.

5 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

6 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”

7 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”

8 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

9 How Is the Premium For An Option Determined? Question: What would you be willing to pay for the right to sell a futures contract at $3.00 if the current futures price is $2.80? Answer: If the premium is under $.20, you could make a profit by exercising the option $3) and buy a futures contract for $2.80 at the same time, making a $20 profit.

10 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

11 Components of Premium Intrinsic Value + Time Value = Premium

12 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

13 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.

14 Components of Time Value Time Volatility Interest rates Underlying futures price Strike price

15 Time Decay Days to expiration Time value

16 Options are said to be: In the money (ITM) – have intrinsic value Out of the money (OTM) – have no intrinsic value

17 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

18 Payoff diagram – Long Call $0.50 $ $0.50 Profit Loss $7.50 $7.00$6.50 $8.50 $8.00 OTMITMATM Buy Beans Price at Expiration Strike Price

19 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

20 Payoff diagram – Long Put $0.25 $ $0.25 Profit Loss $7.50 $7.25$7.00 $8.00 $7.75 ITMOTMATM Buy Beans Price at Expiration

21 What Happens to An Option Which 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

22 Reasons Why a Producer Might Buy Options ActionReason Buys a Put 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.

23 OPTIONS WORKSHEET STRIKE PRICE ___________ - EXPECTED BASIS ___________ - PREMIUM ___________ - COMMISSION ___________ = EXPECTED MIN NET SELLING PRICE ___________

24 Put Option Example Date Cash Futures Option Market Market Market Spring Sell Buy Dec Put Strike=$4 Premium=$.20 Harvest $2.50 Dec. Fut=$3 Sell Dec Put Sell Strike=$4 Buy Premium=$1.20 GAIN……………………..$1………………$1

25 Pricing Alternatives (Falling Market) Date Cash Sale Forward PreHarvest Option At Harvest Contract Hedge ($.20 prem.) Spring $3.40 Sell Dec Buy Put Planting $4 strike Fall Deliver Buy Dec Buy Net Return $2.50 $3.40 $2.50 cash $2.50 cash +$1 fut.=$3.50 +$1 fut-.20=$3.30

26 Pricing Alternatives (Rising Market) Date Cash Sale Forward Pre-Harvest Option At Harvest Contract Hedge ($.20 prem.) Spring $3.40 Sell Dec Buy Put Planting $4 strike Fall Deliver Buy Dec Let Lapse/Die Net Return $4.50 $3.40 $4.50 cash $4.50 cash -$1 fut.=$ =$4.30