1. Commodity Options Markets

2. Options Markets H Are more complex than futures with much more complicated terminology and strategies H Commodity options allow you to either have a short or long futures position at a particular futures price, if you want it, or or provide a position to the buyer if they want it.

3. OptionOption H Contract between two parties that conveys a right but not an obligation to buy or sell a specific commodity futures contract at a specific price within a specific time period for a premium. H Pay premium if buy, receive if sell.

4. Options markets H Traded on major futures exchanges as adjunct to most heavily traded futures contracts H Options were made legal again in mid-1980s after 50 years; prior history of “bucket shops” fleecing customers led to their ban

5. Options markets H Options on cash products were not legal unless delivery was required; others had to be traded on an exchange H Now CFTC is beginning a trial options program which allows some merchandisers to offer options contracts on cash products

6. Types of Options CALL Right to Long Position Buy (Long) Sell (Short) Right to Acquire Obligation to Long Position Deliver Long

7. Types of Options Types of Options PUT Right to Short Position Buy (Long) Sell (Short) Right to Acquire Obligation to Deliver

8. Option Components H Underlying Commodity Futures H Strike Price H Expiration Date H Seller H Buyer H Premium

9. Components of Option Premium Intrinsic Value + Time Value TOTAL VALUE

10. Intrinsic Value H Strike Price minus current Futures Price H Only “better” strike prices vs. futures have intrinsic value;

11. Time Value H Volatility of Underlying Futures H Higher implies bigger time value H Interest Rates H premiums vary directly with interest rates for calls; opposite for puts.

12. Time value H Time till expiration H Longer means larger H More opportunity for futures to move H Declines faster as expiration nears

13. Premium value H Is an option fairly priced? H Sophisticated computer programs are available, and used by professionals H But which option makes the most sense for you?-- a difficult issue.

14. Put and call values H Higher when the option offers a better deal than the current futures price level H Puts--futures lower than strike price H Calls--futures higher than strike

15. PutPut Out-of-the-money Strike Price < Futures Price At-the-money Strike Price = Futures Price In-the-money Strike Price > Futures Price

16. CallCall In-the-money Strike Price < Futures Price At-the-money Strike Price = Futures Price Out-of-the-money Strike Price > Futures Price

17. HedgesHedges H Futures Hedge Used to establish a price level Must post margin H Options Hedge Used to establish floor or ceiling price. No margin required for buyers. Price insurance.

18. Operating Realities H Alternative to futures Buyers limit purchase or sales prices, but can benefit more than futures from price moves the “other” direction.

19. Operating realities Ratio of changes in premium vs futures= DELTA Option premiums change slower than futures contract values

20. Standard strategies H Buy put to establish minimum selling price H Buy call to establish maximum purchase price H Can convert to futures, take opposite options position, or let expire

21. Evaluation of Option Hedges H Long hedge by buying calls Call Strike + Premium + Expected Basis + Commission = Ceiling H Short hedge by buying puts Put Strike - Premium + Expected Basis - Commission = Floor Price

22. CommissionCommission H Charged at half turn rates H Buy or sell and expire1/2 H Buy and sell1/2 + 1/2 H Buy and convert to futures and 1/2 + 1/2 + 1/2 futures and 1/2 + 1/2 + 1/2 reverse position reverse position

23. Buy call Buy Dec $2.80 call option at $.31 Expect basis of $-.12 Minimum purchase price = ?? In October, sell call at $.03; buy corn at $2.68; buy corn at $2.68; Net cost = ??

24. Buy call Buy Dec $2.80 call option at $.31 Expect basis of $-.12 Min. purchase price = 2.80 +.31 -.12 + comm = 2.99 +.005 or.01 In October, sell call at $.03; buy corn at $2.68; Net cost = 2.68 +.31 -.03 +.01 = 2.97

25. Buy put Buy Dec $2.80 put option at $.31 Expect basis of $-.12 Minimum selling price = ?? In October, sell put at $.03; sell corn at $2.68; sell corn at $2.68; Net selling price = ??

26. Options Assignment 1 H Assume local basis of $-.25, and 1/2 turn commission of 1/2 cent/bu. H Calculate February minimum selling and maximum purchase prices for: H corn H soybeans based on today’s close.

27. Options assignment 1 H On February 26, assume relevant Soybean futures4.00 or 5.00 Corn futures1.50 or 2.50 and basis is what you expected. H What are your net results?? H Compare those results with a futures hedge instead of options?

28. Options Assignment 2 H Use today’s closing futures/options prices for lean hogs, and calculate the: H Assume March 15 delivery, 74 % dress %, $3.00 basis (carcass), $25 half turn commission H expected hedged live sales price H best options-based min cash price

29. Selling options H Unlimited risk; margin required H Can be used to acquire premium income to supplement cash market income H Caps revenue or cost potential H Sometimes used to offset premium costs in complex options strategies

30. Selling options H Best left to the experts and those willing to take on high risk Amateurs beware!! H Can use to supplement cash prices, but establishes cap on those prices H Can use buy put-sell call combo to simulate a futures short hedge

31. Sell Cash / Long Call H Sell cash grain & buy a call H Often advocated by market strategists H Is speculative, since no cash position. But keeping cash is speculative too.

32. Sell Cash / Long Call H Advantages: Minimum Selling Price Established Immediate Cash Flow Market Rally Improves Selling Price No Storage Related Costs/Problems Contract Guaranteed

33. Sell Cash / Long Call H Disadvantages Cash price reduced by premium paid Loss of time value would have to be made up by changes in futures prices Speculation, since no cash position

34. Sell Cash / Long Call Evaluation H In Falling Market Min. Price = Cash Price - Call Premium H In Rising Market Max. Price = Cash Price + Call Option Profit ( sell premium minus buy premium)

35. Sell Cash/Long Call Evaluation H Assume At Harvest (Nov 19, 1998) Dec. Futures = $2.42, Cash = $2.13 March ‘99 Corn futures= $2.53 March 2.60 Calls @ $0.21 Expected Basis Feb. 25 vs Mar. Futures = - $0.20;comm = $.01 Storage @ $0.04 per month

36. Sell Cash / Long Call Example H Hold and Store Strategy MarchCashStorage - = Net - = Net FuturesPriceCostPrice A. 2.252.05.121.93 B. 2.802.60.122.48 C. 3.203.00.122.88

37. Sell Cash / Long Call Example H Sell Cash / Long Call Strategy MarchCashOptionsNet + = + = FuturesPriceProfit/Loss Price A. 2.25 B. 2.80 C. 3.20

38. Sell Cash / Long Call Example H Sell Cash / Long Call Strategy MarchCashOptions Net + = + = FuturesPriceProfit/Loss Price A. 2.252.13 -.21 B. 2.802.13 -.21correct? C. 3.202.13+.39

39. Sell Cash / Long Call Example H Sell Cash / Long Call Strategy MarchCashOptions Net + = + = FuturesPriceProfit/Loss Price A. 2.252.13 -.211.92 B. 2.802.13 -.21wrong?1.92 C. 3.202.13+.392.52 minus commissions (How much?)

40. Cattle feeder options hedge H Buy a fed cattle put H Sell a fed cattle call H Gets premium from selling call to offset premium paid to buy put H If at same strike prices, it’s like a futures short position--not worst case price

41. Options/futures combo H Sell futures, buy call -- option is like a stop loss H Buy futures, buy a put -- option is like a stop loss H In the short run, option may not fully offset futures price changes

42. Delta affects hedge effectiveness H Premium changes differ from futures and cash price changes!! Changes in out-of-the-money options are low vs. futures H Changes for in the money options get close to 1 : 1 H Changes at-the-money are near.50

43. H Out-of-the-money option delta values increase as time to maturity increases H In-the-money option delta values decrease as time to maturity increases H At-the-money option delta values are not significantly affected by time to maturity until near expiration Delta or hedge effectiveness

44. When are options a good choice? H When available margin money is limited? H When price risk is very high, and sustained price moves could be large? H When production risk is high? But, premiums can be high!

45. OptionsOptions H Offer a complicated risk management alternative H Offers some risk reduction at known up-front cost H Always will be between cash or futures in profitability H Complicated strategies considered in senior and graduate mktg classes

46. You should be able to evaluate payoffs from: H Options hedge H Futures hedge H Sell cash or contract, buy call H Cash only (store?) H Forward contract H Hedge to arrive and similar H Price later mktg strategies

47. Options Assignment 3 H You are considering buying 1000 20# early weaned feeder pigs next month @ $50/hd, buying corn, and selling 250# hogs 5 months later. H Assume 3# corn per pound of gain, other feed and operating costs of $45, $13 fixed costs per pig, 2% death loss

48. Options Assignment 3 H Assume live hogs have 74% dressing %, and your hogs receive $2 over CME futures mkt. prices H Assume corn prices are $.20/bu. below CBOT, delivered your farm H Calculate expected profit per head using today’s (a) futures; (b) options