Becoming Familiar With Options

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Becoming Familiar With Options
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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

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Objective 1

• Define Options

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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.

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Objective 2

• Understand Puts and Calls

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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

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Objective 3

• Define Strike Price and Premiums

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Objective 3 Define Strike Price

• The price at which a holder of an option may
  exercise it
• These are set prices from the broker

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Objectives3 Define Premiums

• Are traded by open cry in the trading pits
• Two components
• Intrinsic Value
• Time Value

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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

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Objective 3 Define Premiums

• 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 the 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

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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

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Objective 4

• Describe intrinsic value and time value

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Objective 4Intrinsic 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

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Objective 4Intrinsic value (cont)

• 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
• 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

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Objective 4Intrinsic value (cont)

• 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 the 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

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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

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Objective 5

• Understanding how options are traded

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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.

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Think, Pair, Share
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Objective 6

• Understand various option strategies and how they
  can be utilized for hedging crops or livestock

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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.

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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.

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Objective 6 Various option strategies and how
they can be utilized for hedging crops or
livestock

• Todays date is May 1st and the following option
  strike prices and premiums are available for
  August KCBOT HRW wheat contract

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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??

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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

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Objective 6 Various option strategies and how
the can be utilized for hedging crops or livestock

• On July 10th Jim is ready to sell his wheat crop.
  The August KCBOT HRW wheat contract is now
  currently trading at 3.30. Well assume the
  basis is exactly as he expected of 30 cents
  under, so the cash price for wheat is currently
  3.00

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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

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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

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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.

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Objective 6 Various option strategies and how
the can be utilized for hedging crops or livestock

• Jim sells cash wheat _at_ 3.00
• Gain on Option 0.20
• Minus the Option Premium 0.20
• Net Price Received 3.00
• This is a Perfect Hedge

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ANY QUESTIONS

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