ECON 339 X Agricultural Marketing Chad Hart Assistant

ECON 339 X: Agricultural Marketing Chad Hart Assistant Professor chart@iastate. edu 515 -294 -9911 Econ 339 X, Spring 2011 John Lawrence Professor jdlaw@iastate. edu 515 -294 -7801

Options Ø What are options? Ø An option is the right, but not the obligation, to buy or sell an item at a predetermined price within a specific time period. Ø Options on futures are the right to buy or sell a specific futures contract. Ø Option buyers pay a price (premium) for the rights contained in the option. Econ 339 X, Spring 2011

Option Types Ø Two types of options: Puts and Calls Ø A put option contains the right to sell a futures contract. Ø A call option contains the right to buy a futures contract. Ø Puts and calls are not opposite positions in the same market. They do not offset each other. They are different markets. Econ 339 X, Spring 2011

Put Option Ø The Buyer pays the premium and has the right, but not the obligation, to sell a futures contract at the strike price. Ø The Seller receives the premium and is obligated to buy a futures contract at the strike price if the Buyer uses their right. Econ 339 X, Spring 2011

Call Option Ø The Buyer pays a premium and has the right, but not the obligation, to buy a futures contract at the strike price. Ø The Seller receives the premium but is obligated to sell a futures contract at the strike price if the Buyer uses their right. Econ 339 X, Spring 2011

Options as Price Insurance Ø The person wanting price protection (the buyer) pays the option premium. Ø If damage occurs (price moves in the wrong direction), the buyer is reimbursed for damages. Ø The seller keeps the premium, but must pay for damages. Econ 339 X, Spring 2011

Options as Price Insurance Ø The option buyer has unlimited upside and limited downside risk. ØIf prices moves in their favor, the option buyer can take full advantage. ØIf prices moves against them, the option seller compensates them. Ø The option seller has limited upside and unlimited downside risk. ØThe seller gets the option premium. Econ 339 X, Spring 2011

Option Issues and Choices Ø The option may or may not have value at the end ØThe right to buy at $4. 00 has no value if the market is below $4. 00. Ø The buyer can choose to offset, exercise, or let the option expire. Ø The seller can only offset the option or wait for the buyer to choose. Econ 339 X, Spring 2011

Strike Prices Ø The predetermined prices for the trade of the futures in the options Ø They set the level of price insurance Ø Range of strike prices determined by the futures exchange Econ 339 X, Spring 2011

Options Premiums Ø Determined by trading in the marketplace Ø Different premiums Ø For puts and calls Ø For each contract month Ø For each strike price Ø Depends on five variables Ø Strike price Ø Price of underlying futures contract Ø Volatility of underlying futures Ø Time to maturity Ø Interest rate Econ 339 X, Spring 2011

Option References Ø In-the-money Ø If the option expired today, it would have value Ø Put: futures price below strike price Ø Call: futures price above strike price Ø At-the-money Ø Options with strike prices nearest the futures price Ø Out-of-the-money Ø If the option expired today, it would have no value Ø Put: futures price above strike price Ø Call: futures price below strike price Econ 339 X, Spring 2011

Options Premiums Dec. 2011 Corn Futures $5. 76 per bushel In-the-money Out-of-the-money Econ 339 X, Spring 2011 Source: CBOT, 3/20/09

Setting a Floor Price Ø Short hedger Ø Buy put option Ø Floor Price = Strike Price + Basis – Premium – Commission Ø At maturity Ø If futures < strike, then Net Price = Floor Price Ø If futures > strike, then Net Price = Cash – Premium – Commission Econ 339 X, Spring 2011

Short Hedge Graph Sold Dec. 2011 Corn @ $5. 76 Net = Cash Price + Futures Return Econ 339 X, Spring 2011

Put Option Graph Put Option Dec. 2011 Corn @ $5. 80 Premium = $0. 77 Net = Cash Price + Put Option Return Econ 339 X, Spring 2011

Put Option Graph Put Option Dec. 2011 Corn @ $5. 80 Premium = $0. 77 Econ 339 X, Spring 2011

Out-of-the-Money Put Option Dec. 2011 Corn @ $4. 50 Premium = $0. 18 Econ 339 X, Spring 2011

In-the-Money Put Option Dec. 2011 Corn @ $7. 00 Premium = $1. 61 Econ 339 X, Spring 2011

Setting a Ceiling Price Ø Long hedger Ø Buy call option Ø Ceiling Price = Strike Price + Basis + Premium + Commission Ø At maturity Ø If futures < strike, then Net Price = Cash + Premium + Commission Ø If futures > strike, then Net Price = Ceiling Price Econ 339 X, Spring 2011

Long Hedge Graph Bought Dec. 2011 Corn @ $5. 76 Net = Cash Price – Futures Return Econ 339 X, Spring 2011

Call Option Graph Call Option Dec. 2011 Corn @ $5. 80 Premium = $0. 73 Net = Cash Price – Call Option Return Econ 339 X, Spring 2011

Call Option Graph Call Option Dec. 2011 Corn @ $5. 80 Premium = $0. 73 Econ 339 X, Spring 2011

Combination Strategies Ø Option fence Ø Buy put and sell call Ø Higher floor, but you now have a ceiling Ø Put spread Ø Buy At-the-money put and sell Out-of-the-money put Ø Better net price at middle and higher prices, but no floor below Out-of-the-money strike price Econ 339 X, 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 Econ 339 X, 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 Econ 339 X, Spring 2011

Combination Strategies Ø Butterfly Ø Straddle Ø Condor Ø Strangle Ø These positions can be flipped Econ 339 X, Spring 2011

Summary on Options Ø Buyer ØPays premium, has limited risk and unlimited potential Ø Seller ØReceives premium, has limited potential and unlimited risk Ø Buying puts ØEstablish minimum prices Ø Buying calls ØEstablish maximum prices Econ 339 X, Spring 2011

Class web site: http: //www. econ. iastate. edu/~chart/Classes/econ 339/ Spring 2011/ Econ 339 X, Spring 2011