ECON 337:

1
ECON 337 Agricultural Marketing

Chad Hart Associate Professor chart_at_iastate.edu 51
5-294-9911
Lee Schulz Assistant Professor lschulz_at_iastate.edu
515-294-3356
2
Options

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

3
Option Types

• Two types of options Puts and Calls
• A put option contains the right to sell a futures
  contract.
• A call option contains the right to buy a futures
  contract.
• Puts and calls are not opposite positions in the
  same market. They do not offset each other.
  They are different markets.

4
Put Option

• The Buyer pays the premium and has the right, but
  not the obligation, to sell a futures contract at
  the strike price.
• The Seller receives the premium and is obligated
  to buy a futures contract at the strike price if
  the Buyer uses their right.

5
Call Option

• The Buyer pays a premium and has the right, but
  not the obligation, to buy a futures contract at
  the strike price.
• The Seller receives the premium but is obligated
  to sell a futures contract at the strike price if
  the Buyer uses their right.

6
Options as Price Insurance

• The person wanting price protection (the buyer)
  pays the option premium.
• If damage occurs (price moves in the wrong
  direction), the buyer is reimbursed for damages.
• The seller keeps the premium, but must pay for
  damages.

7
Options as Price Insurance

• The option buyer has unlimited upside and limited
  downside risk.
• If prices moves in their favor, the option buyer
  can take full advantage.
• If prices moves against them, the option seller
  compensates them.
• The option seller has limited upside and
  unlimited downside risk.
• The seller gets the option premium.

8
Option Issues and Choices

• The option may or may not have value at the end
• The right to buy corn futures at 6.00 per bushel
  has no value if the market is below 6.00.
• The buyer can choose to offset, exercise, or let
  the option expire.
• The seller can only offset the option or wait for
  the buyer to choose.

9
Strike Prices

• The predetermined prices for the trade of the
  futures in the options
• They set the level of price insurance
• Range of strike prices determined by the futures
  exchange

10
Options Premiums

• Determined by trading in the marketplace
• Different premiums
• For puts and calls
• For each contract month
• For each strike price
• Depends on five variables
• Strike price
• Price of underlying futures contract
• Volatility of underlying futures
• Time to maturity
• Interest rate

11
Option References

• In-the-money
• If the option expired today, it would have value
• Put futures price below strike price
• Call futures price above strike price
• At-the-money
• Options with strike prices nearest the futures
  price
• Out-of-the-money
• If the option expired today, it would have no
  value
• Put futures price above strike price
• Call futures price below strike price

12
Options Premiums
June 2013 Live Cattle Futures 128 per cwt.
In-the-money
Out-of-the-money
Source CME, 2/5/13
13
Setting a Floor Price

• Short hedger
• Buy put option
• Floor Price Strike Price Basis
  Premium Commission
• At maturity
• If futures lt strike, then Net Price Floor Price
• If futures gt strike, then Net Price Cash
  Premium Commission

14
Put Option Graph
Put Option June 2013 Live Cattle _at_ 128
Strike Price 128
Put Option Return Max(0, Strike Price Futures
Price) Premium Commission
Premium 3.275 Commission 0.01
15
Put Option Graph
Put Option June 2013 Live Cattle _at_ 128 Premium
3.275
Net Cash Price Put Option Return
16
Short Hedge Graph
Sold June 2013 Live Cattle _at_ 128
Net Cash Price Futures Return
17
Short Hedge Graph
Sold June 2013 Live Cattle _at_ 128
Net Cash Price Futures Return
18
Comparison
19
Out-of-the-Money Put
Put Option June 2013 Live Cattle _at_ 120 Premium
0.80
20
Out-of-the-Money Put
Put Option June 2013 Live Cattle _at_ 120 Premium
0.80
21
In-the-Money Put
Put Option June 2013 Live Cattle _at_ 132 Premium
5.625
22
In-the-Money Put
Put Option June 2013 Live Cattle _at_ 132 Premium
5.625
23
Comparison
24
Setting a Ceiling Price

• Long hedger
• Buy call option
• Ceiling Price Strike Price Basis
  Premium Commission
• At maturity
• If futures lt strike, then Net Price Cash
  Premium Commission
• If futures gt strike, then Net Price Ceiling
  Price

25
Call Option Graph
Call Option Dec. 2013 Corn _at_ 6
Strike Price 6
Call Option Return Max(0, Futures Price
Strike Price) Premium Commission
Premium 0.50 Commission 0.01
26
Call Option Graph
Call Option Dec. 2013 Corn _at_ 6 Premium 0.50
Net Cash Price Call Option Return
27
Long Hedge Graph
Bought Dec. 2013 Corn _at_ 5.9375
Net Cash Price Futures Return
28
Comparison
29
Summary on Options

• Buyer
• Pays premium, has limited risk and unlimited
  potential
• Seller
• Receives premium, has limited potential and
  unlimited risk
• Buying puts
• Establish minimum prices
• Buying calls
• Establish maximum prices

30

• Class web site
• http//www.econ.iastate.edu/chart/Classes/econ337
  /Spring2013/
• Lab in Heady 68.