Agricultural Options Tutorial

  1. Chapter 1: The Benefits of CBOT Agricultural Options
  2. Chapter 2: CBOT Agricultural Options: Concepts and Definitions
  3. Chapter 3: Option Pricing and Premium
  4. Chapter 4: Alternatives for Exiting Option Contracts
  5. Chapter 5: Basic Option Applications for Speculators
  6. Chapter 6: Basic Option Applications for Hedgers
  7. What’s Next?

Chapter 1: The Benefits of CBOT Agricultural Options

Since the Chicago Board of Trade introduced agricultural options in 1984, interest and trading volume have skyrocketed. Whether you are a speculator looking for a return on capital or a hedger seeking price protection, there are many reasons to use CBOT agricultural options.

The benefits of CBOT agricultural options:

Flexibility

No matter what the market scenario – higher prices, lower prices, or even static prices – agricultural options can help speculators and hedgers achieve their objectives.

Versatility

Options can be used for purposes beyond expressing a price opinion. There are also opportunities to profit from changes in market volatitity, decreasing time to expiration, or other factors unique to options.

Price protection combined with opportunity

Agricultural options are ideal for establishing price protection without limiting favorable price opportunity.

Liquidity

Like CBOT future contracts, CBOT option contracts are highly liquid – allowing efficient entry and exit.

Limited risk

Risk exposure can be significantly reduced by using options. Buers can rest assured that their exposure is no greater than the premium paid for the option.

Financial integrity

The CBOT has oversight, audit, and clearing systems in place to eliminate counter-party risk. Unlike contracts between private parties, your trades are guaranteed by the clearing system.

Chapter 1 Quiz

CBOT agricultural options provide the following benefits:

  1. Versatility, financial integrity, and limited opportunity
  2. Flexibility, liquidity, and exposure to unlimited risk
  3. Flexibility, versatility, and liquidity

Options provide a mechanism to:

  1. Maintain flexibility under various market conditions
  2. Limit risk and maintain opportunity
  3. Both A and B

Counter-party risk is not a factor when trading CBOT agricultural options.

  1. True
  2. False

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Chapter 2: CBOT Agricultural Options: Concepts and Definitions

An option provides the right, but not the obligation to buy or sell an agricultural futures contract at a specified price by a specified date. Buyers of CBOT agrictural options hold the rights but not the obligations to buy or sell an underlying (link) agricultural futures contract at a specific price. In contrast, sellers of CBOT agricultural options assume obligations to buy or sell an underlying agrictultural futures contract at a specific price if the option is exercised (link) by the buyer.

Just like futures, agricultural options are bought and sold by competitive auction on a futures exchange.

Are all traded on the CBOT!

There are two types of options: CALLS and PUTS

Call Options

A call option gives the option buyer the right to buy (go long) the underlying futures contract at a specified price. When exercised, the call option buyer receives an underlying long futures position and the call option seller is assigned an underlying short futures position.

Put Options

A put option gives the option buyer the right to sell (go short) the underlying futures contract at a specificed price. When exercised, the put option buyer receives an underlying short futures position and the put option seller is assigned an underlying long futures position.

For each call and put option, there are a series of specified futures price levels available. These specified price levels are known as strike prices. For example, a 2.40 December Corn call option that gives the buyer the right to buy December Corn futures at a specified price of $2.40 is said to have a $2.40 strike. Several strikes are available for each option.

The right to buy or sell an agricultural futures contract at a specific price by a certain date has a cost. That cost, value or price of an option is called premium. The premium depends on multiple factors including market volatitlity, time (number of days) until expiration, interest rates, and supply and demand for an option. The actual premium of an option is discovered through the CBOT auction process.

Chapter 2 Quiz

A call option conveys which of the following:

  1. The right to be short a futures contract
  2. The obligation to be long a futures contract
  3. The right to be long a futures contract

What happens when a put option owner exercises their option?

  1. The put owner becomes short futures
  2. The put seller becomes long futures
  3. The option is exercised at the specified strike price
  4. All of the above

Which of the following are components of both puts and calls?

  1. Buyer and seller
  2. Underlying commodity
  3. Strike price
  4. Expiration date
  5. All of the above

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Chapter 3: Option Pricing and Premium

Option premium is the combination of two components; Intrinsic Value & Time Value.

Intrinsic Value + Time Value = Premium

Intrinsic Value

Intrinsic value is the amount an option would be worth if it was exercised immediately given the current futures price level. In other words, if an option holder can exercise at a better price than the current futures price, it has intrinsic value.

A call has intrinsic value if the strike price is less than that of the underlying futures price. Why?

Because the right to own futures at a level less than the underlying futures price has economic value.

For a call: Futures Price – Strike Price = Intrinsic Value

Click here for an example

A put has intrinsic value if the strike price is greater than that of the underlying futures price. Why?

Because the right to sell futures at a level great than that of the underlying futures price has economic value.

For a put: Put Strike Price – Futures Price = Instrinisc Value

Click here for an example

Time value represents the amount that buyers are willing to pay, in addition to any intrinsic value, for hte possibility that an option will be worth exercising at some later date.

If an option has no intrinsic value, then the entire premium is comprised of time value.

Example Option Premium Table

Click on the numbers in orange to see their intrinsic and time value

Futures Jan 598.50
Strike Price Call Premiums Put Premiums
580 40.25 21.75
590 35.00 26.50
600 30.25 31/75
610 26.25 37.25
620 22.50 44.00
630 19.50 50.75

Factors Affecting Time Value

The Underlying Futures Price Relative to the Option Strike Price

Time value is usually greatest when the futures price is near the option strike price. This is because the option has a relatively high probability of gaining intrinsic value. In the case of an option with significant intrinsic value (known as deep-in-the-money), there is less time value because there is a high probability the option will retain its intrinsic value.

An option without intrinsic value and a strike very far from the current market (also known as deep-out-of-the-money) will also have less time value as the probability that the option will gain intrinsic value is quite low.

There are some common option classifications used to describe an option relative to the futures market:

  Call Option Put Option
In-the-money Strike price < Futures price Strike price > Futures price
At-the-money Strike price = Futures price Strike price = Futures price
Out-of-the-money Strike price > Futures price Strike price < Futures price

Time (number of days) until expiration

The longer the time until expiration, the great the possibility the option will become worth exercising and therefore the higher the premium demanded by option sellers.

Market Volatility

The greater the volatility of the underlying futures contract, the higher the time value of an option. Option sellers demand a higher premium in more volatile markets because of the greater possibility that the option will be worth exercising.

Supply and Demand

The willingness, urgency, and number of option buyers and sellers impacts the option price (premium) at any given time.

Interest Rates

Although, the effect of interest rates on time value is minimal, higher interest rates will lower the premiums.

Chapter 3 Quiz

The difference between an option’s premium and the option’s intrinisc value is:

  1. The strike price
  2. The underlying futures contract price
  3. Time value

If the underlying futures price is $2.75, then the $2.50 Corn call option is classified as:

  1. At-the-money
  2. Out-of-the-money
  3. In-the-money

What is the current intrinsic value of a $6.50 Soybean put option when the underlying futures price is $6.00?

  1. $0.00
  2. – $0.50
  3. + $0.50

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Chapter 4: Alternatives for Exiting Option Positions

Once an option position has been established, there are three ways to exit that position:

  • Exercise the option
  • Offset the option
  • Let the option expire

Exercise

If an option is exercised, the option buyer and seller will be assigned opposing positions in the underlying futures contract. Only the option buyer can initiate the exercise process, which is fairly simple. The option buyer notifies their broker of their intent to exercise and the broker, in turn, submits an exercise notice to the clearing service provider. The exercise is then enacted prior to the opening of the next trading day.

The clearing service provider creates a new futures position at the strike price for the buyer. Simultaneously, the clearing service provider assigns an opposite futures position at the same strike price to a randomly selected seller of the same option. The entire exercise procedure is completed before the start of trading on the next business day.

Futures Position after Option Exercise

  Call Option Put Option
Buyer Assumes Long Futures Short Futures
Seller Assigned Short Futures Position Long Futures Position

Offset

Similar to futures, offsetting is the most common method of closing an option position. To offset, you sell a put or a call identical to the put or call initially purchased; or you buy a put or call identical to the one you initially sold.

Both the option buyer and option seller can offset their position at any time in the life of an option.

Initial Position Offsetting Position
Long Call Sell Identical Call
Short Call Buy Identical Call
Long Put Sell Identical Put
Short Put Buy Identical Put

Offsetting has some distinct advantages for both the optoin buyer and the option seller. First, for the option holder, offsetting allows you to capture any remaining time value in addition to intrinsic value. Offsetting an option also eliminates the risk inherent in a futures position.

For the option seller, offsetting an option position eliminates the risk of being exercised against and assigned an unwanted futures position. It is important to recognize that calls (the right to buy) and puts (the right to sell) convey completely different rights. It is also important to understand that calls and puts are distinctly different contracts and are not offsetting positions. This means they do not represent opposite sides of the same transaction.

Expire

By doing nothing, an out-of-the-money option can simply be allowed to expire. Many out-of-the-money options expire worthless on their last trading day. An option owner can wait until just prior to expiration deciding whether to exercise an option or not. They then have the benefit of knowing if market price is better or worse than the option strike and have risked no more than the premium paid.

If the option strike is out of the money through expiration, the option seller has the advantage of keeping the entire premium. It is important to remember that CBOT agricultural options follow a different trading schedule than the underlying futures contract. Standard options typically expire the third week of the month prior to the underlying futures contract expiration. For example, November Soybean options expire the third week in October whereas November Soybean futures continue to trade until mid-November.

Chapter 4 Quiz

When a call option is exercised, the holder assumes:

  1. A short futures position
  2. A neutral futures position
  3. A long futures position

If a put option is exercised, the option seller:

  1. Is assigned a short futures position
  2. Is assigned a long futures position
  3. Is assigned a long option position

To offset a long call option position, the call owner:

  1. Sells a similar put option
  2. Buys a similar put option
  3. Sells a simliar call option

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Chapter 5: Basic Option Applications for Speculators

Options provide investors with a multitude of ways to express a market opinion while seeking a return on capital. The wide array of possible strategies offer a choice of limited or unlimited opportunity combined with limited or unlimited risk.

Buying an option, either a call or put, provides an investor with unlimited profit opportunity. At the same time, risk is limited to no more than the premium paid. Selling an option, whether a call or put, provides an investor with limited profit opportunity, the premium received, and unlimited risk.

There are also many ways to both buy and sell options in various combinations to achieve an objective, with varying degrees of risk and rewards. However, this chapter will focus on the following strategies:

  1. Long Call
  2. Long Put
  3. Short Call
  4. Short Put

Applying a Strategy

For the following speculative strategies, let’s assume July Wheat futures are trading at $3.50 and July Wheat options are as shown in this table. Note, the examples do not include transaction costs.

Strike Price Calls Puts (in cents/bu)
350 25 5
350 19 9
350 12 12
360 9 19
370 5 25

Strategy 1: Long Call

Profit or Loss Potential: Buying a call option provides unlimited profit potential when the underlying futures market moves higher and provides limited loss potential if the underlying futures market moves lower.

Example: Buy an at-the-money 350 July Wheat call for 13 cents, conveying the right to own July Wheat futures at $3.50.

Strategy 1: Long Call Results at Expiration

[graph]

Strategy 2: Long Put

Profit or Loss Potential: Buying a put option provides unlimited profit potential when the underlying futures market moves lower and provides limited loss potential if the underlying futures market moves higher.

Example: Buy an at-the-money 350 Wheat put for 12 cents conveying the right to sell July futures at $3.50.

Strategy 2: Long Put Results at Expiration

[graph]

Strategy 3: Short Call

Profit or Loss Potential: Selling a call option provides a limited profit potential if the underlying futures moves lower and unlimited risk potential as the underlying futures market moves higher.

Example: Sell an out-of-the-money 360 July Wheat call for 9 cents creating the potential obligation to be short July Wheat futures at $3.60 if the option is exercised.

Strategy 3: Short Call Results at Expiration

[graph]

Strategy 4: Short Put

Profit or Loss Potential: Selling a put option provides limited profit potential if the underlying futures market moves higher and unlimited loss potential if the underlying futures moves lower.

Example: Sell an out-of-money 340 July Wheat put for 8 cents creating a potential obligation to be long July Wheat futures at $3.40 if the option is exercised.

Strategy 4: Short Put Results at Expiration

[graph]

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Chapter 6: Basic Option Applications for Hedgers

Options provide hedgers with many ways to reduce or elminate the inherent price risk associated with buying or selling physical commodities. Options offer hedgers alternative strategies to limit risk – in different ways and at different cost levels. And, unlike hedging with futures, options also allow hedgers to retain a choice of limited or unlimited market opportunity.

Simply buying an option provides a hedger with unlimited price protection.

The following option strategies will be reviewed and evaluated:

Applying a Strategy – Long Hedger

Let’s assume you are the buyer for a wheat milling company. Your company is interested in using options to hedge, or protect, against higher prices for wheat you will purchase for processing at a later date. The expected basis for your location is 10 cents over the July futures price.

It is now March and July Wheat futures are trading at $3.50. July Wheat option prices are as follows:

Strike Price Calls Puts (in cents/bu
330 25 5
340 19 9
350 12 12
360 9 19
370 5 25

Strategy – Long Call

Profit or Loss Potential: This strategy provides unlimited price protection in a higher market between March and late June when the option expires. The risk in a lower market is limited to the premium paid.

Example: Buy (go long) an at-the-money 350 July Wheat call for 13 cents. This position conveys the right to buy July Wheat futures at $3.50.

Applying a Strategy – Long Hedge Results at Expiration

[graph]

Net cash purchase:

Futures price + Basis – Gain or + Loss on the long call.

The gain or loss represents the option’s intrinsic value minus the initial premium (cost) of the option. The gain is subtracted since a gain in the long call will lower (improve) the net cash purchase price. Whereas, a loss will be added sinceit increase the net purchase price.

As the calculations indicate, as the market moves higher, the maximum cost to the buyer is $3.73.

This price ceiling is initially established as follows:

Strike Price $3.50
+ Expected Basis + $0.10
+ Cost of option + $0.13
= Price ceiling = $3.73

If the market drops, the buyer benefits as the cash market price also falls.

As this example illustrates, the long call provides unlimited price protection in a higher market and also unlimited opportunity in a lower market, adjusted for the option cost.

Applying a Strategy – Short Hedger

Let’s assume you are a corn producer interested in using options to hedge, or protect, againstl ower prices for your crop. The expected basis for your location is 20 cents under the December futures price.

It is now March and July Corn futures are trading at $2.50.

July Corn option prices are as follows:

Strike Price Calls Puts (in cents/bu)
230 25 5
240 20 10
250 13 13
260 9 19
270 5 25

Strategy – Long Put

Profit or Loss Potential: This strategy provides unlimited price protection in a lower market between March and late November when the option expires. The risk in a higher market is limited to the premium paid.

Example: Buy (go long) an at-the-money 250 December Corn put for 13 cents. This position conveys the right to sell December Corn futures at $2.50 per bushel.

Applying a Strategy – Short Hedge Results at Expiration

[graph]

Net cash selling price:

Futures price + Basis + Long Put Gain or – Long Put Loss

The gain or loss represents the option’s intrinsic value minus the initial premium (cost) of the option. The profit is added since the gain will increase the net cash selling price. Whereas, a loss will be subtracted since it decreases the effective selling price.

As the calculations indicate, as the market moves lower, the minimum selling price is $2.17.

This price floor is established as follows:

Strike Price $2.50
+ Basis – $0.20
– Cost of the option – $0.13
= Price Floor = $2.17

If the futures market rises, the producer benefits as the cash market price also rises and the put option loss is limited to the initial premium paid.

As this example illustrates, the long put provides unlimited price protection in a lower market and also unlimited opportunity in a higher market, adjusted for hte initial option premium paid.

What’s Next?

Another tutorial

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