WHAT ARE OPTIONS OPTIONS TRADING

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1 OPTIONS TRADING WHAT ARE OPTIONS Options are openly traded contracts that give the buyer a right to a futures position at a specific price within a specified time period Designed as more of a protective measure against volatile markets. Not necessarily the best profit opportunity 1

2 OPTIONS Options are a very good way for hedgers to protect themselves without worrying about margin calls. Remember: LIMITED RISK, LIMITED REWARD 85% of all options expire worthless, but most had made money at some point during the life of the contract WHY USE OPTIONS? No exposure to margin calls. The premium you pay to purchase the option is all that is at risk. In return for the premium, you have established an effective price floor or ceiling (depending on the option) 2

3 TYPES OF OPTIONS Two Types of Options: PUT OPTIONS CALL OPTIONS PUT OPTIONS PUT OPTIONS: Give the buyer the right but not the obligation to a short position in the futures market Used to protect downside risk Primary tool of hedgers in a production situation: Establishes a price floor on your grain 3

4 CALL OPTIONS Call Options: Give the buyer the right but not the obligation to a long futures position Protects upside risk Used for hedging purposes by buyers and end users (feedlots, livestock production, grain buyers, etc) Components of an Option Underlying Futures Contract- The month and commodity that the option gives you a right to buy or sell. Strike Price-Price at which the buyer has a right Sell (Put) or Buy (Call). Premium-Amount buyer pays for protection provided by option 4

5 Components of an Option Option Buyer-one who pays premium and receives protection Option Seller- also referred to as writer. Is obligated to take the opposite position of buyer should the buyer choose to exercise How are Premium Values Decided? Premium Values reflect two things: Intrinsic Value Time Value 5

6 Methods of Selling (con t) Option Premium Components Intrinsic value + Time value = Total value Intrinsic value = Strike price +/- underlying futures price Needs to be in-the-money to have Time value risk Volatility of underlying futures pay more when markets are more volatile Interest rates very minor influence Option classification closer to at-the-money the higher the time value Time the further out in time the higher the value Intrinsic Value Intrinsic Value refers to the how valuable the put would be today if the option were exercised STRIKE PRICE-FUTURES PRICE (PUT) FUTURES-STRIKE PRICE (CALL) 6

7 Intrinsic Value Option Strike Price Terms In The Money (ITM) For Put Option- futures price is lower than strike price For Call Option-futures price is above strike price Option prices will increase and buyers are able to collect profit. Sellers will lose premium received and also go on margin call Intrinsic Value At The Money (ATM) For Put and Call options, Strike Price = Futures Price At this point, both puts and calls would expire worthless Buyer would lose premium paid and seller would collect entire premium received 7

8 Intrinsic Value Out of the Money: Put: Futures price is HIGHER than the strike price Calls: Futures Price is LOWER than the strike price Buyer would lose premium paid and seller would collect entire premium received 2 nd Component: Time Value Time value on options reflects risk Influenced by: Amount of time until expiration Volatility of the market Option classification: In the money, etc Interest rates (very small influence) 8

9 Time Value Any factor, with the exception of strike price, that affects the chance of option being exercised Examples: longer time until expiration or high market volatility Delta Delta: Measure of how responsive option premiums are to a change in the underlying futures value Varies from commodity to commodity 9

10 Example: Delta If futures change 10 cents and option premiums change 3 cents Change in options / Change in futures = 3 cents / 10 cents = Delta of.3 Methods of Selling (con t) Option Alternatives Expire Lose right to make claim and lose premium paid Exercise Only get intrinsic value, usually no time value Offset Do opposite action, if bought call sell call 10

11 Option Strategies For Hedgers: Buy Puts Sell Calls In some situations, a combination of both will help offset the premium for the put The combination of both synthetic short position Summary Options work very well when used correctly Similar to insurance Pay premium in return for protection against adverse prices Locks in a floor price and transfers risk to seller of call Basis is the remaining risk 11

12 Questions? 12

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