1 Agribusiness Library Lesson 060062: Options. 2 Objectives 1.Describe the process of using options...

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Agribusiness Library

Lesson 060062: Options

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Objectives

1.Describe the process of using options on futures contracts, and define terms associated with options.

2.Distinguish between put and call options, and explain why options are used.

3.Describe how option pricing is determined.

4.Explain the advantages and disadvantages of trading options.

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Terms

actual options at-the-money call options exercise futures options in-the-money intrinsic value life

margin call option out-of-the-money premium put options strike price time value time value of

money

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• What is the process of using options on futures contracts?• What are some of the terms associated with options?

An option is a right, not an obligation, to purchase or sell a specific product at a specific price on or before a certain date. An individual can buy or sell if he or she wants to, but the person is not required by law to do so. The main reason to buy an option (actual or futures) is to minimize financial risk.

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A. A couple basic features are true for options.

1. The premiums paid for futures options are market determined and will vary depending on:

a. Interest rateb. Time left before the contract expiresc. The strike priced. Others

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2. If a person chooses not to exercise an option, he or she can offset it by selling a like contract.

3. If a person lets the contract expire, he or she will forfeit the premium.

4. Options can eliminate the need for a margin account (money put up front in case of losses occurring).

5. They can also potentially allow higher prices for the producer.

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6. Buying futures options is like buying price insurance against falling market prices. It is also like buying cost protection against rising market prices if a person purchases grains and other products as an input for a business.

a. If a person is an owner of a feed lot, he or she could lock in a purchase price for feed by buying futures options.

b. If a person is trading in the market or buying feed for a farm, he or she can look at options as price insurance.

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B. Exercise is the conversion of an option into a demand for performance on the underlying contract. If someone uses an option and actually buys a product before the contract expires, it is called exercise.

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B. Exercise (example) 1. Bobby has a car he would like to sell for $2,500. Billy thinks he would like it, so he enters an option contract with Bobby for 60 days. (The life of an

option is determined by the futures contract it covers.) Billy then has 60 days to consider the purchase.

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B. Exercise (example) 2. During the 60 days, Bobby cannot sell the

car to anyone else, but Billy can decide at any time that he does not want the car. If Billy buys the car, he is exercising his option. If he does not buy

the car, he can let the option expire. Then Bobby will have to find someone else to purchase the car.

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C. When contracts like the previous example are made, the buyer pays a premium to the seller. A premium is the price that an option contract trades for a given strike price. Because the seller must take his or her product off the market during the option contract, he or she needs some compensation in case the buyer does not exercise the option and no sale is made. The

buyer and seller agree upon the premium.

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D. The price that an option contract will be converted into the underlying position is a

strike price. When Bobby and Billy enter into the option, they would agree that Billy pay an agreed upon premium. The premium will be subtracted from the strike price if the final purchase is made. So if the strike price is $2,500 and the premium is $500, Billy will still

owe Bobby $2,000 if the purchase is made.

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E. There are actual and futures options.1. Actual options are used with the transfer

of real property because there is a physical product being sold.

2. Futures options are used when a buyer is purchasing an overlaying contract to buy

or sell the futures contract at a specified price and within a specified period of time.

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• What is the difference between put and call options? • Why are options used?There are two different types of options: put options and call options.A. Put options are for individuals who sell or put commodities on the market.

1. Put options are used to set minimum price and benefits from price increases.

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• What is the difference between put and call options? • Why are options used?A. Put options (cont’d)

2. Put options can be offset (sell the same put), exercised (exchanged for a short futures contract at the strike price), or expire (e.g., if the put option is worthless, nothing is done, and it is sold

in the cash market). The main idea of a put option is to lock in a minimum price for the

sale of a commodity. With a put option, a person can benefit from rising prices.

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• What is the difference between put and call options? • Why are options used?B. Call options are for individuals who buy or call commodities on the market.

1. Call options are used to set the maximum price and benefits from price decreases.

2. Call options can be offset (sell the same call), exercised (exchanged for long futures

contracts at the strike price), or expire (e.g., if the call option is worthless, nothing is done, and it is purchased in the cash market). The main idea of a call option is to lock in a maximum price for the

purchase of a commodity.

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• What is the difference between put and call options? • Why are options used?C. Options are used as a marketing tool to provide the producer with price protection. Producers can also take advantage of prices moving toward their benefit with the use of options. When using

options, a producer does not have to worry about margins.

Trading options among speculators will be conducted to make a profit based on the

premiums.

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• How are the prices for premiums and strike prices on options determined?

Options contracts are traded in a similar fashion as futures contracts. Not all futures contracts have options, and all delivery months do not have option contracts. It is best to for people to research all of the necessary information before trading.

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A. Strike prices are set by each individual exchange. The standard practice used

to determine the strike price for the day is to take the settle price from the last trading day.

1. From the settle price, a predetermined set of fixed intervals is used to set at least three strike prices above and three below the price that is as close to the settle price as possible.

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2. The settle price is the final price used each day to value futures and options contracts. It involves the actual last traded price and a weighted average of the last trades during the last few minutes of the trading day.

3. Using the three above and three below method provides at least seven available strike

prices to trade at each day.

4. As trading occurs, the market moves up and down. When this happens, additional strike prices are added.

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5. Every strike price is available to be traded after it is set. For example, if Treasury bonds settled at $85, the available strike prices to trade today would be: Treasury Bonds at $85 Strike Prices

$88$87$86$85$84$83$82

These prices would all be available to be traded. The $1 intervals are predetermined by the Chicago Board of Trade, along with the premiums at each price.

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B. Many things influence the actual value of premiums. The following are some of

the major factors:1. If the option is a put or a call2. The length of time until maturity—The

premium will be higher if the maturity time is longer because more time allows for more changes to

occur.

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3. The price level of the underlying futures contract4. The volatility of the actual commodity—The

premium will be higher if the level of price vitality is higher because it means higher risk to the seller.

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C. The time value of money is the opportunity cost of money and considers what other things a person could have done with the money in the

same period of time and what profits could have been received.

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1. The factors of maturity time and volatility are called time value. Time value is the

amount of the option premium that reflects the trader’s expectations of future value.

2. The amount added to the premium is based on volatility and time until maturity.

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D. The difference between the price of theunderlying (futures) contract and the

strike price is the intrinsic value.1. If the option has a positive intrinsic value, it

is called in-the-money.2. If the intrinsic value is negative, it is called

out- of-the-money.3. If the intrinsic value is zero, the option is

called at-the-money.

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• What are the advantages and disadvantages of trading options?

There are many trading strategies used in futures trading. Using options is one of them. Like all other trading, there are advantages and disadvantages.

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A. Advantages1. A person who buys options does not face

margin calls when faced with a put or a call. A margin call is the amount of money that must be deposited with the broker to maintain a losing futures or options position. In other words, it is

a set amount of money put down to ensure that traders do not fall short of their financial

obligations when trading. An option is not an obligation, so no margin calls are faced.

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B. Disadvantages1. A premium must be paid. It is the

cost of doing business. On one hand, an individual could lose the premium if he or she does not exercise an option, but the person can profit if the price is right to do so.

2. The entire price of the premium must be paid at the time of purchase. How much money a person has to trade with will limit how much he or she can purchase.

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B. Disadvantages

3. Because option premiums consider the time value of money, if a person buys an option, he or she is holding an eroding asset. Therefore, he or she may end up profiting by the trade, but the

contract is not gaining any worth unless the person exercises it and profits by doing so.

If someone had put the same amount of money in a savings account or a savings bond, it would be collecting interest instead of staying the same.

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B. Disadvantages4. A person must be very educated with his or

her decisions. Even though options may look easy and foolproof, they involve a complex strategy that requires the seller to become educated on market strategies. Time and knowledge are required to

be profitable.

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A. Advantages2. Options allow price protection on growing

crops without commitment. This way the owner of the option can watch the market and make a decision to proceed based on the current information.

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A. Advantages3. There is minimal risk. In the options market,

the maximum financial risk is the price of the premium paid to have the option. If a

person does not exercise his or her option, the most he or she can lose is what was paid for the premium.

4. An individual has the assurance to benefit if the market price is favorable, but he or she also insures against unfavorable market prices.

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Review

What is the difference between actual options and future options?

What are some of the major factors that influence the actual value of premiums?

What are some advantages of trading options?

What are some disadvantages of trading options?

1 Agribusiness Library Lesson 060062: Options. 2 Objectives 1.Describe the process of using options...

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