Introduction to Options. Commodity & Ingredient Hedging, LLC

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1 Introduction to Options Commodity & Ingredient Hedging, LLC

2 Options on Futures: Price Protection & Opportunity Copyright 2009 Commodity & Ingredient Hedging, LLC 2

3 Option Contract: Technical Definition Contract between two parties that conveys a right but not an obligation to buy or sell a specific commodity at a specific price within a specific time period for a premium. Copyright 2009Commodity & Ingredient Hedging, LLC 3

4 Option Contract: Basic Definition Contract that provides the RIGHTS to a specific purchase or sale price for a future delivery. Copyright 2009Commodity & Ingredient Hedging, LLC 4

5 Futures versus Options FUTURES OBLIGATIONS Long futures: establishes a purchase price Short futures: establishes a sale price OPTIONS RIGHTS Long call: establishes a maximum purchase price Long put: establishes a minimum sale price Copyright 2009Commodity & Ingredient Hedging, LLC 5

6 Types of Options CALLS Contains the right to BUY PUTS Contains the right to SELL Copyright 2009Commodity & Ingredient Hedging, LLC 6

7 Option Components Buyer holder Seller writer or grantor Underlying Commodity a futures contract Strike Price exercise price Expiration Date rights expire Premium price, cost, or value of rights Copyright 2009Commodity & Ingredient Hedging, LLC 7

8 Wheat Options: Contract Specifications Underlying: 5,000 Bushel Futures Contract Standard option (same month as futures) Serial (all other months) Tick Size: 1/8 Cent/Bu ($6.25/contract) Strike Price Interval: 5 cents (first two months) 10 cents (all other months) Copyright 2009Commodity & Ingredient Hedging, LLC 8

9 Soybean Oil Options: Contract Specifications Underlying: 60,000 pound Futures Contract Standard option (same month as futures) Serial (all other months) Tick Size:.005 cents per pound ($3.00/contract) Strike Price Interval:.50 cents per pound Copyright 2009Commodity & Ingredient Hedging, LLC 9

10 Option Positions CALL OPTION Buyer of call has rights to buy futures Seller of call has obligation to sell futures Long call and short call are offsetting positions PUT OPTION Buyer of put has rights to sell futures Seller of put has obligation to buy futures Long put and short put are offsetting positions Copyright 2009Commodity & Ingredient Hedging, LLC 10

11 Components of Premium INTRINSIC VALUE + TIME VALUE PREMIUM Copyright 2009Commodity & Ingredient Hedging, LLC 11

12 Intrinsic Value Components Strike price Underlying futures price Calls Strike price < futures price Puts Strike price > futures price Copyright 2009Commodity & Ingredient Hedging, LLC 12

13 What is Intrinsic Value? A Call option has intrinsic value if the strike price is less than the futures price. Example: May Corn futures = $4.45 May $4.00 call option = $0.45 A Put option has intrinsic value if the strike price is greater than the futures price. Example: May Corn futures = $4.45 May $5.00 put option = $0.55 Copyright 2009Commodity & Ingredient Hedging, LLC 13

14 Call Option Classifications In the Money Call Strike Price < Futures Price At the Money Call Strike Price = Futures Price Out of the Money Call Strike Price > Futures Price Copyright 2009Commodity & Ingredient Hedging, LLC 14

15 Put Option Classifications In the Money Put Strike Price > Futures Price At the Money Put Strike Price = Futures Price Out of the Money Put Strike Price < Futures Price Copyright 2009Commodity & Ingredient Hedging, LLC 15

16 Time Value: Components Time The more time to expiration the greater the time value Volatility The greater the volatility the greater the time value Interest Rates The greater the interest rate the greater the time value Supply & Demand Via bids and offers (heavier bid volume relative to offers will increase time value, heavier offer volume relative to bids will decrease time value) Copyright 2009Commodity & Ingredient Hedging, LLC 16

17 Time Value Curve Time value Decreases at an increasing rate Time value is zero at option expiration Time value Cents/bushel Days to expiration 0 Copyright 2009Commodity & Ingredient Hedging, LLC 17

18 What is Time Value? The premium (price) of an option less its intrinsic value. Example #1: May Wheat futures = $6.25 May $6.00 Wheat call premium = $0.55 What is the time value? Example #2: May Wheat futures = $6.25 May $6.40 Wheat put premium = $0.70 What is the time value? Copyright 2009Commodity & Ingredient Hedging, LLC 18

19 Premium Movement Premiums change when futures prices change Call premiums move in the same direction as futures Puts premiums move in the opposite direction as futures If futures prices increase Call premiums increase Put premiums decrease If futures prices decrease Call premiums decrease Put premiums increase Copyright 2009Commodity & Ingredient Hedging, LLC 19

20 Wheat Option Values, July Dec 2009 Copyright 2009Commodity & Ingredient Hedging, LLC 20

21 What Happens to Options Expire Exercise Offset Copyright 2009Commodity & Ingredient Hedging, LLC 21

22 Option: Expire Options expire: month prior to the underlying futures Grain & Oilseed options stop trading on the last Friday preceding the first notice day of the underlying futures by at least 2 business days Options have zero value after expiration Automatic exercise of options Options that have value on the last trading day will be automatically exercised into futures unless the option buyer declines their exercise right. Copyright 2009Commodity & Ingredient Hedging, LLC 22

23 Option: Exercise Exercise Notes Only the option buyer can exercise the rights A seller is randomly selected to fulfill the rights Calls Call option buyer exercises a long futures position Call option seller gets assigned a short futures position Puts Put option buyer exercises a short futures position Put option seller gets assigned a long futures position Copyright 2009Commodity & Ingredient Hedging, LLC 23

24 Option: Offset Offset Notes Most options are offset Most cost efficient alternative Requires the opposite position in the same option Same strike price, month, type and commodity Calls Buying a call offsets an existing short call position Selling a call offsets an existing long call position Puts Buying a put offsets an existing short put position Selling a put offsets an existing long put position Copyright 2009Commodity & Ingredient Hedging, LLC 24

25 Exercise versus Offset Offset recovers both intrinsic and time value Exercise recovers only intrinsic value Remaining time value is lost Exercise may have additional costs Exercise may have additional risks Copyright 2009Commodity & Ingredient Hedging, LLC 25

26 Volatility Classifications Future Volatility: Price movements that occur from the present to the expiration of the option. Impossible to know what the future holds. Expected Volatility: An estimate of future volatility. Inexact, but most traders have an opinion on volatility. Historical Volatility: Actual volatility during a specific time period in the past. Implied Volatility: The volatility that justifies an option s current price. Seasonal Volatility: Volatility in certain commodities that can be greatly affected by production cycles. Copyright 2009Commodity & Ingredient Hedging, LLC 26

27 Option Implied Volatility Measure of an option s cost Computed based on option pricing models such as Black/Scholes, others that uses the option s premium and underlying futures price as inputs to determine the volatility implied by the option s settlement price. Seasonal and Historical Trends Positive Relationship to Price (the higher the implied volatility, the higher the option s premium) Changes in Volatility can slow down or speed up the rate of time decay in an option. Copyright 2009Commodity & Ingredient Hedging, LLC 27

28 Volatility: Key Concepts If all other factors remain the same then An increase in volatility will increase the time value of an option premium. A decrease in volatility will decrease the time value of an option premium. Generally: If you expect volatility to increase then you want to be long options. If you expect volatility to decrease then you want to be short options. Copyright 2009Commodity & Ingredient Hedging, LLC 28

29 Seasonal Volatility Chart December Wheat Options Copyright 2009Commodity & Ingredient Hedging, LLC 29

30 Historical Volatility Chart December Wheat Options

31 END Commodity & Ingredient Hedging, LLC

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