Becoming Familiar With Options Becoming Familiar With Options

Becoming Familiar With Options

Becoming Familiar With Options Objectives: Define options Understand puts and calls Define strike price and premiums and understand how options are traded Describe intrinsic value and time value Understanding how options are traded Understand various option strategies and how they can be utilized for hedging crops or livestock

Objective 1 Define Options

Objective 1: Define Options Is like purchasing an insurance policy It protects you from the unexpected market rise or drop You are charged a premium for the service You are only financially liable for the premium and not margin calls unless the option is exercised in which it becomes a futures contract and all the rules for futures applies An option is not necessarily the most profitable method of price protection; however, it does expose you to the least amount of risk.

Objective 2 Understand Puts and Calls

Objective 2: Understanding Puts and Calls Puts Gives you the right but not the obligation to sell futures contract P is close to S so it means to sell Calls Gives you the right but not the obligation to buy a futures contract C is close to B so it means to buy

Objective 3 Define Strike Price and Premiums

Objective 3: Define Strike Price The price at which a holder of an option may exercise it These are set prices from the broker

Objectives 3: Define Premiums Are traded by open cry in the trading pits Two components Intrinsic Value Time Value

Objective 3: Define Premiums Intrinsic Value Is the amount of money, if any, that could be realized if the option is exercised An option is in the money (ITM) if the option has intrinsic values If the strike price is below the current futures price Example: a soybean call with a $7. 00 strike price and the current futures price is $7. 50 this call would be ITM Example: a Soybean put and the current futures price is $7. 50 then the put would be ITM if the strike price is $8. 00 An option is out of the money (OTM) if the option has no intrinsic values

Objective 3: Define Premiums o Intrinsic Value (cont. ) If the strike price is above the current futures price Example: A soybean call with a strike price of $7. 00 and a futures price of 6. 50 the call is OTM Example: a soybean put with a strike price of $7. 00 would be OTM if the current futures price is $7. 50 An option is at the money (ATM) if there is no intrinsic value and the strike price and future price are equal Example: a soybean call with a $7. 00 strike price and the current futures price is $7. 00 the call is said to be ATM

Objective 3: Define Premiums Time Value Time and Volatility primarily make up the time value component Four Factors Actual length of time remaining until expiration Volatility of the underlying futures price Whether the option is ITM or OTM Short term risk free interest rates •

Objective 4: Describe intrinsic value and time value

Objective 4: Intrinsic value Is the amount of money, if any, that could be realized if the option is exercised An option is in the money (ITM) if the option has intrinsic values o If the strike price is below the current futures price o Example: a soybean call with a $7. 00 strike price and the current futures price is $7. 50 this call would be ITM

Objective 4: Intrinsic value (cont) o Example: a Soybean put and the current futures price is $7. 50 then the put would be ITM if the strike price is $8. 00 An option is out of the money (OTM) if the option has no intrinsic values o If the strike price is above the current futures price o Example: A soybean call with a strike price of $7. 00 and a futures price of 6. 50 the call is OTM

Objective 4: Intrinsic value (cont) o Example: a soybean put with a strike price of $7. 00 would be OTM if the current futures price is $7. 50 An option is at the money (ATM) if there is no intrinsic value and the strike price and future price are equal o Example: a soybean call with a $7. 00 strike price and the current futures price is $7. 00 the call is said to be ATM

Objective 4: Time Value Time and Volatility primarily make up the time value component Four Factors Actual length of time remaining until expiration Volatility of the underlying futures price Whether the option is ITM or OTM Short term risk free interest rates

Objective 5: Understanding how options are traded

Objective 5: Understanding how options are traded Gives you the option but not the obligation to deliver, take delivery or let it expire(offset) With an option you pay a premium to have the option to deliver or take delivery if you chose to exercise it or you can let it expire and just pay the premium.

Think, Pair, Share

Objective 6: Understand various option strategies and how they can be utilized for hedging crops or livestock

Objective 6: Various option strategies and how they can be utilized for hedging crops or livestock Farmer Jim has a target price of $3. 00 for his upcoming wheat crop. Options are more appealing to Jim because he knows the cost of the price protection in the beginning and will not have to worry about margin calls. When determining an expected price from using options to hedge, it is exactly the same as when doing it for futures except we also include the premium. So the expected price or minimum floor price for a put would be found by option strike price – premium +/- basis.

Objective 6: Various option strategies and how they can be utilized for hedging crops or livestock For example, if Jim is looking at a put with a strike of $3. 50 and option premium of of 20 cents and he expects the basis to be 30 cents under, his floor price on the option would be the following: Option Strike Price $3. 50 - Premium $0. 20 - Basis $0. 30 = Minimum Floor Price $3. 00 Jim knows, therefore, that in order to reach his target price of $3. 00 on his wheat, he will have to probably look at a put strike price of $3. 50 or higher.

Objective 6: Various option strategies and how they can be utilized for hedging crops or livestock Today’s date is May 1 st and the following option strike prices and premiums are available for August KCBOT HRW wheat contract: Strike Price Premium Basis Min. Floor Price $4. 00 $0. 80 -$0. 30 2. 90 $3. 80 $0. 65 -$0. 30 $2. 85 $3. 50 $0. 20 -$0. 30 $3. 00 $3. 20 $0. 10 -$0. 30 $2. 80

Objective 6: Various option strategies and how the can be utilized for hedging crops or livestock Jim chooses the $3. 50 strike price at a premium of $0. 20. This option will cost $1000 in total for 5000 bu wheat contract ANY QUESTOINS? ?

Objective 6: Various option strategies and how the can be utilized for hedging crops or livestock Jim has 3 alternatives with his option: Let it expire if the current market price is below his strike price Sell a put option equal to the one he currently holds and collect the premium Exercise the option into the underlying futures contract

Objective 6: Various option strategies and how the can be utilized for hedging crops or livestock On July 10 th Jim is ready to sell his wheat crop. The August KCBOT HRW wheat contract is now currently trading at $3. 30. We’ll assume the basis is exactly as he expected of 30 cents under, so the cash price for wheat is currently $3. 00

Objective 6: Various option strategies and how the can be utilized for hedging crops or livestock The following are the options and their premiums available Strike Price Premium $3. 50 $0. 15 $3. 30 $0. 02 $3. 00 $0. 01

Objective 6: Various option strategies and how the can be utilized for hedging crops or livestock Note the change is premium since May. We know there are two parts to the premium: time value and intrinsic value and the time value is comprised heavily on actual time until expiration and volatility. The time value was much greater in May because of the length of time until August. Now since we are nearing expiration, the time value is little and volatility makes up the balance

Objective 6: Various option strategies and how the can be utilized for hedging crops or livestock Jim decides to exercise his $3. 50 option. Jim calls his broker and tells him his intentions of exercising his option into a futures contract. After the option is exercised, Jim then immediately buys back the futures contract at $3. 30. This nets Jim a gain on his option of 20 cents, but the Option costs him 20 cents premium.

Objective 6: Various option strategies and how the can be utilized for hedging crops or livestock Jim sells cash wheat @ Gain on Option Minus the Option Premium Net Price Received This is a Perfect Hedge $3. 00 $0. 20 $3. 00

ANY QUESTIONS Stand up an turn around three times if you understand. Then sit back down in your chair.