Producer Marketing Management: Primer on Agricultural Options1 By Gerald Campbell Reviewers: Dave Holder and Randy Corley, Edited for this publication by Duane Griffith and Stephen Koontz2 When Congress passed the Futures Trading Act contracts and explores applications of options of 1982, it paved the way for a new marketing for agricultural producers. management tool for farmers and others who market agricultural products. This law What is an Agricultural Commodity Option? authorized the development of a pilot program It is easy to be confused by the term “option,” for organized trading of agricultural commodity because the term means several different things options. This overturned a 4-year-old ban on in the jargon of the commodity industries. For commodity options trading in agricultural example, marketers might refer to a particular products. futures contract as the “December corn option” or simply the “December option.” But there is The discussion that follows is intended to an important difference between a futures introduce newcomers to agricultural options contract and a commodity option. trading. It defines some options terms, outlines differences between options and futures 1 This publication has been modified slightly from its original version. The glossary has also been removed and two sections were added on Hedging and Trading Strategies. 2 By Gerald Campbell, College of Agricultural and Life Sciences, University of Wisconsin-Madison and the University of Wisconsin Cooperative Extension Service; Reviewers: David Holder, ES, USDA and Randy Corley, ES USDA; NCR Extension Publication No. 217. Sponsored by the Extension services of Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota and Wisconsin in cooperation with ES-USDA. Edited for this publication by Duane Griffith, Montana State University, and Stephen Koontz, Colorado State University. Article 3.2 Page 1 of 15 A futures contract traded on the nation's If the buyer buys the right to buy at a specific commodity exchanges carries a joint obligation price, he has bought a call option. The buyer of for both buyer and seller. The contract buyer the call option has purchased the right to buy a must take delivery or take an offsetting commodity futures contract from the seller of position. The seller must make delivery or take the call at a specified price. The seller of an offsetting position. With a commodity options is sometimes called an option writer or option, however, there is no joint obligation. grantor. This comes from the fact that The seller of a commodity option sells the historically it was the seller who determined buyer the right—or option—to take or make delivery, but the buyer has no obligation to do so. The buyer of the commodity option may Call = Right to exercise this option, but the seller cannot force buy a futures him to do so. This distinction is important in contract some time understanding why someone would find options in the future. more useful than futures contracts for accomplishing a particular marketing purpose. (CB or Call equals Buy) Options and futures do have common features: Both are concerned with actions that will occur in the future. Both options and futures have what rights would be sold. There are both limited economic life. A futures contract has a buyers and sellers of puts and buyers and sellers delivery date and a commodity option has an of calls. So there are separate but related expiration date. Both dates limit the time period markets for put options and call options. in which these instruments have economic value. Agricultural option markets are developed by organized commodity exchanges, and option Puts, Calls, Strike Prices and Premiums contracts are based on existing futures The buyer of an agricultural option must contracts. So trading takes a form similar to determine what “right” he wishes to buy. If the futures trading: the exchange proposes to trade buyer buys the right to sell at a specific price, options on futures contracts for a particular this is a put option. In this case, if the option is agricultural commodity— soybeans, for exercised, the option seller must provide the example. The exchange defines the quantity option buyer with a sell position in the associated with each option, the quality underlying futures contract at the price characteristics, the delivery times and the specified in the option. delivery locations. In other words, each exchange develops standardized options contracts so that all traders understand what is being traded. Put = Right to sell a futures contract In addition to these specifications, the exchange some time in the also proposes trading option contracts at several future. strike prices. Options derive their value from the price specified in the option contract. (PS or Put equals This is called the strike price and is specified Sell) when an option is first made available for trading. Page 2 of 15 Article 3.2 For example, suppose that an exchange has bushel might watch the premium go over $1.00 approval to trade options for soybean futures as soybean prices rise. He could then sell the contracts, and that the option specifies a option to someone else and make his profit by contract for 5,000 bu. of No. 1 yellow soybeans, “offset” rather than exercise. As an option, deliverable in Chicago on January 1st at a strike trader he would watch the movement in options price of $7.00 per bushel. The exchange would premiums to determine his profit or loss. The allow simultaneous trading in both put and call table on page four and at the end of this article options, with buyers and sellers for each. The show a typical listing for options premiums on a price someone pays for an option is called the given day. premium. The premium is established through competitive bids and offers. The value of the One important point about options premiums: premium depends on how high or low buyers When the buyer purchases either a put or call think the price of the commodity will go, how option, his dollar commitment is fixed for the volatile the market for that commodity has life of the option. He knows with certainty the been, and how soon the option will expire. cost of the right he has purchased. He does not have to worry about margin accounts. This is an How Much is an Option Worth? important difference between trading options In order to understand how a buyer might and trading futures contracts. In trading futures decide how large a premium he is willing to contracts, the size of the obligation for buyers pay, consider the soybean option outlined and sellers changes as the price of the above. Suppose the trader thinks soybean prices commodity changes. So margin accounts will rise during the next six months. Our trader change in value and additional deposits may be also knows that soybean prices have been quite required. In options trading the buyer is assured volatile recently, and thinks they could go over that the initial cost of the option is the limit of $8.00 per bushel. He knows that six months is the buyers cost. The buyer can lose no more plenty of time for the soybean market to reach than the amount paid to purchase the option. his price objective. So he concludes that he This is not true for the option seller, as will should be a buyer. As a buyer, he thinks he become clear later. could make a profit by buying a call option with a termination date six months from now and a In the Money, Out of the Money strike price of $7.00. If he expects beans to go Because the prices of the underlying to over $8.00 per bu. he might be willing to pay commodities can move over a wide range, nearly $1.00 per bushel in premium. If he does commodity exchanges offer options with so, it should be profitable to exercise the option several strike prices. This gives traders a range when the price of soybeans goes over $8.00. of options. If an option's strike price is such that Generally, as the exercise date for the option exercise of the option would give positive approaches, the option premium will approach returns, it is said to be in the money. the difference between the cash price of the commodity and the strike price of the option. For example, a put option for corn futures with a strike price of $3.00 per bushel is in the We would expect that most traders who owned money whenever corn futures prices are below an option and could profit if they exercised that $3.00 per bushel. The buyer of this put can sell option would sell the option to someone else corn futures for less than $3.00 per bushel, and profit from the sale. A trader who paid a exercise the option and force the seller to take $1.00 premium for a soybean call option (the the corn futures at $3.00 per bushel. Similarly, a right to buy) with a strike price of $8.00 per call option for corn futures at $3.00 per bushel Article 3.2 Page 3 of 15 Sep 22, 1998 3:30 pm CST - Daytime Corn Wheat Oats 98Dec 99Mar 99May 99Jul 98Dec 99Mar 99May 99Jul 98Dec 99Mar 2050 2312 2710 3070 1164 2176 2252 2862 2960 1242 3080 Opening 9:00 9:00 9:04 9:31 9:11 9:00 pm 9:02 pm 9:04 pm 3:15 am 9:32 am pm pm pm am pm 2746 2990 3090 1164 2196 2272 2332 2896 1252 2072 1:14 10:03 1:14 9:41 9:41 am 9:41 am 9:43 am 1:14 pm 9:43 am Session 9:41 am pm am pm am 2170 2246 2310 2864 a 1240 High/Low 2046 2712 2964 3064 1150 11:48 11:47 11:45 10:33 10:35 9:30 am 10:32 10:32 9:32 9:31 am am am am am am am am am 2746 3090 1164 2072 2196 2272 2332 2990 1252 1:14 2896 1:14 9:11 9:41 am 9:41 am 9:41 am 9:43 am 10:03 9:43 am