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Econ 339X, Spring 2011 ECON 339X: Agricultural Marketing Chad Hart Assistant Professor chart@iastate.edu 515-294-9911 John Lawrence Professor jdlaw@iastate.edu 515-294-7801
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Econ 339X, Spring 2011 Options What are options? An option is the right, but not the obligation, to buy or sell an item at a predetermined price within a specific time period. Options on futures are the right to buy or sell a specific futures contract. Option buyers pay a price (premium) for the rights contained in the option.
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Econ 339X, Spring 2011 Option Types Two types of options: Puts and Calls A put option contains the right to sell a futures contract. A call option contains the right to buy a futures contract. Puts and calls are not opposite positions in the same market. They do not offset each other. They are different markets.
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Econ 339X, Spring 2011 Put Option The Buyer pays the premium and has the right, but not the obligation, to sell a futures contract at the strike price. The Seller receives the premium and is obligated to buy a futures contract at the strike price if the Buyer uses their right.
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Econ 339X, Spring 2011 Call Option The Buyer pays a premium and has the right, but not the obligation, to buy a futures contract at the strike price. The Seller receives the premium but is obligated to sell a futures contract at the strike price if the Buyer uses their right.
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Econ 339X, Spring 2011 Options as Price Insurance The person wanting price protection (the buyer) pays the option premium. If damage occurs (price moves in the wrong direction), the buyer is reimbursed for damages. The seller keeps the premium, but must pay for damages.
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Econ 339X, Spring 2011 Options as Price Insurance The option buyer has unlimited upside and limited downside risk. If prices moves in their favor, the option buyer can take full advantage. If prices moves against them, the option seller compensates them. The option seller has limited upside and unlimited downside risk. The seller gets the option premium.
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Econ 339X, Spring 2011 Option Issues and Choices The option may or may not have value at the end The right to buy at $4.00 has no value if the market is below $4.00. The buyer can choose to offset, exercise, or let the option expire. The seller can only offset the option or wait for the buyer to choose.
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Econ 339X, Spring 2011 Strike Prices The predetermined prices for the trade of the futures in the options They set the level of price insurance Range of strike prices determined by the futures exchange
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Econ 339X, Spring 2011 Options Premiums Determined by trading in the marketplace Different premiums For puts and calls For each contract month For each strike price Depends on five variables Strike price Price of underlying futures contract Volatility of underlying futures Time to maturity Interest rate
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Econ 339X, Spring 2011 Option References In-the-money If the option expired today, it would have value Put: futures price below strike price Call: futures price above strike price At-the-money Options with strike prices nearest the futures price Out-of-the-money If the option expired today, it would have no value Put: futures price above strike price Call: futures price below strike price
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Econ 339X, Spring 2011 Options Premiums Dec. 2011 Corn Futures $5.76 per bushel Source: CBOT, 3/20/09 In-the-money Out-of-the-money
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Econ 339X, Spring 2011 Setting a Floor Price Short hedger Buy put option Floor Price = Strike Price + Basis – Premium – Commission At maturity If futures < strike, then Net Price = Floor Price If futures > strike, then Net Price = Cash – Premium – Commission
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Econ 339X, Spring 2011 Short Hedge Graph Sold Dec. 2011 Corn @ $5.76 Net = Cash Price + Futures Return
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Econ 339X, Spring 2011 Put Option Graph Put Option Dec. 2011 Corn @ $5.80 Premium = $0.77 Net = Cash Price + Put Option Return
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Econ 339X, Spring 2011 Put Option Graph Put Option Dec. 2011 Corn @ $5.80 Premium = $0.77
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Econ 339X, Spring 2011 Out-of-the-Money Put Put Option Dec. 2011 Corn @ $4.50 Premium = $0.18
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Econ 339X, Spring 2011 In-the-Money Put Put Option Dec. 2011 Corn @ $7.00 Premium = $1.61
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Econ 339X, Spring 2011 Setting a Ceiling Price Long hedger Buy call option Ceiling Price = Strike Price + Basis + Premium + Commission At maturity If futures < strike, then Net Price = Cash + Premium + Commission If futures > strike, then Net Price = Ceiling Price
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Econ 339X, Spring 2011 Long Hedge Graph Bought Dec. 2011 Corn @ $5.76 Net = Cash Price – Futures Return
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Econ 339X, Spring 2011 Call Option Graph Call Option Dec. 2011 Corn @ $5.80 Premium = $0.73 Net = Cash Price – Call Option Return
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Econ 339X, Spring 2011 Call Option Graph Call Option Dec. 2011 Corn @ $5.80 Premium = $0.73
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Econ 339X, Spring 2011 Combination Strategies Option fence Buy put and sell call Higher floor, but you now have a ceiling Put spread Buy At-the-money put and sell Out-of-the-money put Better net price at middle and higher prices, but no floor below Out-of-the-money strike price
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Econ 339X, Spring 2011 Fence Buy Put Option Dec. 2011 Corn @ $5.50 Premium = $0.59 Sell Call Option Dec. 2011 Corn @ $6.50 Premium = $0.50
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Econ 339X, Spring 2011 Spread Buy Put Option Dec. 2011 Corn @ $6.50 Premium = $1.23 Sell Put Option Dec. 2011 Corn @ $5.00 Premium = $0.35
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Econ 339X, Spring 2011 Combination Strategies Butterfly Condor Straddle Strangle These positions can be flipped
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Econ 339X, Spring 2011 Summary on Options Buyer Pays premium, has limited risk and unlimited potential Seller Receives premium, has limited potential and unlimited risk Buying puts Establish minimum prices Buying calls Establish maximum prices
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Econ 339X, Spring 2011 Class web site: http://www.econ.iastate.edu/~chart/Classes/econ339/ Spring2011/
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