1. How to Reduce Price Risk Through Options
Carl L. German
Extension Crops Marketing Specialist
208 Townsend Hall
University of Delaware
Newark, Delaware

2. Table of Contents Why Consider Using Put Options to Sell Your Grain?
Best Reasons to Consider Options
The Difference Between Puts and Calls
What does a Put Option Do?
Example 1. Buying and Offsetting a Soybean Put Option
Example 2. Net Return When Selling Your Soybean Crop
- Comparing buying a put to hedging, forward cash contracting and/or doing nothing
- Example 2. Described
3. Trading Basics
4. How Options Are Priced
- Intrinsic value, time value, volatility

3. Table of Contents (continued)
- At the money, in the money, and out of the money options
5. Settling Options Positions
- Offset, Expire, Exercise
6. Volatility
7. Costs/Margins
8. Exercise 3. Buying and Offsetting a Corn Put Option
9. Summary
10. Contact Information

4. Why put options shine now
Several factors have come together that give put options new luster:
Grain producers may find that grain elevators have restricted their purchases (amount and how far in advance an individual can contract). Locally, farmers can forward cash contract only 50% of what they have normally contracted (over the past three years) for ’08 production.
The high risk of possibly enormous margin calls on futures hedges makes hedging a risky alternative.
Doing nothing may be the right strategy if an event doesn’t cause the market to fall, but with input costs at record levels, many cannot afford the risk.

5. Best Reasons to Consider Options
Farmers, as grain sellers, can use put options to establish a minimum price for their crops without giving up the chance to profit from higher prices.
Put options offer an opportunity to establish a minimum price (price floor) on that portion of the crop not covered by crop insurance.
As a pricing mechanism, options provide flexibility to a grain seller.
The risk involved in using options is limited to the premium or the cost of the option.

6. Best Reasons to Consider Options (continued)
Using options is typically compared to buying insurance.
Buying options provides price protection; the option works to insure the Minimum Selling Price (MSP) for puts or the Maximum Buying Price (MBP) for calls.
Unlike futures hedging and forward contracting, buying options does not involve a price commitment. The option is simply offset or allowed to expire.
Unlike forward contracting, buying options does not involve a delivery commitment. In the event of a production shortfall, delivery of the bushels covered is not required. D

7. Puts vs. Calls
A put option gives the right to sell the underlying commodity
A call option gives the right to buy the underlying commodity
at the option strike price.
For the purpose of this discussion we will only consider examples of buying put options.

8. What does a put option do?
A grain producer might buy a put option to protect his downside price risk and to take advantage of high price offerings. For example, a grain seller who buys a November put option on soybeans for a $15.20 strike price has the right to sell soybeans in the futures market at $15.20/bu., until a specified date a few weeks before the November futures contract expiration date.
If the market price for soybeans in early October is $15.20/bu., the put is likely to be worth a portion of the remaining time value. The farmer-owner can offset the option to capture the remaining value.
Conversely, if soybeans were bringing $17/bu. at harvest, the farmer would not exercise the right to sell at only $ The option is allowed to expire worthless (much like a term life insurance policy if the holder doesn’t die) so that the seller can take advantage of the higher price, minus the premium cost, (+ or -) the basis, - commission.
See Example 1.

9. Example 1. Buying and Offsetting a Soybean Put Option
Date Cash Options Basis
June Min. Selling Price Nov $ under
Strike Price $15.20 Buy $15.20 Nov soybean (current
Exp. Basis $1.66/bu. offer)
Option Premium
Commission
= MSP $13.18
Oct. Sell cash $14.85 Nov $ under
Sell $15.20 soybean (estimated) $ .15/bu.
Gain or Loss $(1.51/bu.)
Result: Sell cash soybeans $14.85 ($15.20 Nov futures basis) – $1.51 premium cost commission = $13.33 estimated net price/bushel.

10. Example 2. Net Return When Selling Your Soybean Crop (Basis = 35 under)
(Previously Bought $15.00 Put, Hedged, Forward Cash Contracted or Did Nothing)
If Nov futures price Bought $15.00 Put Hedged or
in Oct is for $1.55 Forward Do
premium Contracted Nothing
@$15.00 Nov
futures
$ $ $ $12.65
$ $ $ $13.65
$ $ $ $14.65
$ $ $ $15.65
$ $ $ $16.65
* Excludes commission.

11. Example 2. Described
The example illustrates the put options’ effect on profitability and how buying puts compares to hedging, forward contracting, and/or doing nothing.
When buying a put with a $15.00 strike price – 35 ¢ basis – $1.55 premium, the minimum sales price that one can achieve in the event of a price decline is $13.10/bu.
However, as the November futures price increases, the return from the option begins to perform better than the MSP established.
Doing nothing yields the best net price in the event that the futures price rises above the $15.00 strike price.
When the Nov futures price falls to $13.00/bu or less, the put option outperforms doing nothing. The MSP = $13.10/bu.
In the event of a price decline below the $15.00 strike price purchasing the put option will always perform second best to hedging in the futures market and/or forward cash contracting.

12. Trading Basics
Options are traded on organized exchanges: For example, options for corn, SRW wheat, and soybeans are traded at the Chicago Board of Trade; HRW wheat is traded at the Kansas City Board of Trade.
Options are traded the same way as futures contracts, via open outcry of competitive bids and offers, only it is the premium that is decided in that trading. At any given point in time, one can buy or sell puts and calls at a number of strike prices (the dollar value of the product).
Strike prices are given in per-bushel increments – generally 20 cent increments for soybeans and 10 cent increments for corn and wheat options.
Premiums are quoted in one-eight increments. A premium reading 25.5 would equal 25 4/8 ¢ /bu.
Option quotes can be obtained from various sources on the Internet.

13. How options are priced
Option premiums are priced based on three factors: intrinsic value, time value and volatility.
Figuring an option’s value at expiration is simple. It has only intrinsic value--whatever amount of money the holder could realize by exercising or offsetting the option. If nothing can be realized, the option has no value and it expires worthless.
Intrinsic value – This is the amount of money, if any, that could be realized by exercising or offsetting an option with a given strike price. A put option has intrinsic value if its strike price is above the current futures price. For example, if a corn put option has a strike price of $7/bu. and the underlying futures price is $6.50/bu., the put option has an intrinsic value of 50 ¢ /bu.

14. How options are priced (continued)
During the life of the option contract, intrinsic value + time value = premium. The time value is the sum of money that buyers are currently willing to pay for a given option in the anticipation that over time a change in the underlying futures price will cause the option to increase in value.
At expiration there is no time remaining, the option has no time value.

15. Option Time Value
.75
.60
.45
.30
.15
.05
June Jul Aug Sep Oct Nov Dec

16. option pricing (continued)
An option that has no intrinsic value and only time value remaining will erode in value as the date of expiration for the underlying futures contract approaches, making it less likely the option will gain in value.
Due to the time value, option buyers are generally encouraged to offset their option positions 30 to 45 days prior to the date of expiration of the underlying futures contract.
This allows the option buyer to recover part of the premium cost before the option expires.
Basically, two factors affect an option’s value:
The length of time remaining until expiration.
The volatility of the underlying futures price.

17. option pricing (continued)
All else being equal, the more time an option has remaining until expiration, the higher its premium.
As expiration approaches, the option’s time value erodes. This is why options are sometimes called ‘wasting assets’.

18. option pricing (continued)
Grain sellers usually offset their options rather than exercise them. A grain seller who buys a $7 Dec put in June is likely to offset the option during early November (or sooner) as long as it has intrinsic value. The option is offset at least 30 to 45 days in advance of expiration to take advantage of remaining time value.
Options that expire worthless are not worthwhile to offset or exercise.
When an option expires worthless, the option buyer forfeits the entire amount of the premium paid.

19. option pricing (continued)
Volatility – During times of great market volatility and a greater need for price protection, the cost of obtaining the insurance associated with options is greater and the premiums are higher. The intrinsic value of an option has a better chance of increasing when futures are volatile than when prices are relatively stable, thus, buyers are willing to pay more for the option.

20. option pricing (continued)
At the Money – When the option strike price and the underlying futures price are equal, the option is at the money. At-the-money options do not have intrinsic value.
In the Money – An in-the-money option has intrinsic value and offsetting it provides profit from the option position and/or recaptures (part of) the premium.
Out of the Money – A put option is out of the money if the futures price is above the option strike price--for example, if the corn futures price were currently at $7/bu., a put option with a strike price of $6.50/bu. is 50 cents/bu. out of the money. An out-of-the-money option has no intrinsic value. An option that is out of the money at expiration is allowed to expire worthless.

21. Settling Options Positions
Option buyers can follow one of three courses of action. They can offset, exercise, or allow their options to expire. The action to be taken depends upon whether the option is in, at, or out of the money.
Offset – When a producer originally buys a put, he may sell it in order to close the position. In the case of a call, where the option buyer initially buys a call, the owner sells the call to offset or close the position. Options that are offset are in-the-money options that represent a profit to the buyer of the option.
Expire – The buyer can allow the option to expire. This often happens when the option buyer loses money in the option position, yet makes up the difference (minus the premium cost) in the cash commodity. An option that expires worthless is out-of-the-money.

22. Settling Options Positions (continued)
3. Exercise – The action taken by the buyer (holder) of an option who wishes to acquire a position in the underlying futures contract at the option strike price. Option buyers seldom choose to exercise; typically, the option is offset, thereby taking the profit earned.
Word of Caution – At-the-money and in-the-money options that have not been offset or exercised upon or before expiration will be automatically exercised by the exchange at the strike price at expiration. When exercised, the option buyer receives either a short (for puts) or a long (for calls) futures position and must margin the account according to the rules set forth for commodity hedgers and/or speculators, depending upon the option holder’s cash or non-cash position.

23. Costs/margins
Buying options requires the buyer to deposit good faith money in the form of the premium.
Other than the premium, no additional margin is required.
The premium cost paid is the amount that the option buyer can lose on the option position.
In addition, a commission fee is incurred for a round turn (buying the put and later selling the put to offset it).
Side Note: Margining rules are different for option sellers (writers). Option sellers must margin their accounts. Since option sellers face the same risk as participants in the futures market (hedgers and speculators), they must deposit and maintain adequate funds in a margin account to cover potential losses on a day-to-day basis.

24. Example 3. Buying and Offsetting a Corn Put Option
The next example illustrates buying a put option to establish protection against a possible price decline between June and October. The illustration is presented in two parts. In June, a $7.60 Dec corn put option is bought and in October, it is offset (sold). Note the simultaneous cash and options market transactions and the corresponding basis relationship.

25. Example 3. Buying and Offsetting a Corn Put Option
Date Cash Options Basis
June Min. Selling Price Dec $7.65 even (0)
Strike price $7.60 Buy $7.60 Dec corn (current)
Exp. Basis $.89/bu.
Option Premium -.89
Commission -.01
= MSP $6.70
Oct. Sell cash 7.60 Dec $7.60 even (0)
Sell $7.60 Dec corn (estimated)
$.05/bu.
Gain or loss ($.84/bu.)
Result: Sell cash $7.60 ($7.60 Dec futures basis) - 84¢ premium cost Commission = $6.75 estimated net price/bushel.

26. Summary
The examples used in this presentation are based upon pending decisions. They are not intended to be all inclusive.
The appropriate use of options in a farmers marketing program this summer can help in keeping grain and oilseed sales profitable.
Primary reasons to consider using put options this summer:
Local grain elevators have restricted the amount that they are willing to book via forward contracts
The high risk of enormous margin calls makes hedging a risky venture
To establish minimum prices on that portion of the crop not covered by crop insurance.
Gives farmers the opportunity to make sales at high prices for a known cost while locking in a Minimum Sales Price.

27. For more information
Contact Carl L. German, or
call