Options on Grain Futures Reference

Put Options

 

  • Definition: Puts offer the buyer the right but not the obligation to sell the futures at the strike price at or before the expiration date for the option.  Each contract is for 5,000bu.
  • Producers benefit from the protection of put options as price insurance on unpriced grain production.
  • The Advantages of buying puts:
    • Unlimited downside protection
    • Possible loss from the position is limited to the premium paid, therefore margin calls will not exceed the premium paid plus commissions and fees.
  • The Disadvantages of buying puts:
    • Loses value with the passage of time
      • Extrinsic value is time + volatility
    • Premiums can be expensive especially for long dated options in a volatile market or prior to report days.
  • Example:
    • A producer buys a $4.00 Dec put for $0.20; the breakeven at expiration is 4.00-.20 = $3.80 Dec futures at expiration, anything lower is profit from the hedge. So if this producer sell harvest corn at $3.00 (-.40 basis) futures would be at 3.40.  The hedge could be exited at approx.60 for a .40 cent profit.   Adding this profit back to the harvest sell would result in a price of $3.40 on bushels.

 

 

 

 

 

 

 

Call Options

 

  • Definition: Calls offer the buyer the right but not the obligation to buy the futures at the strike price, at or before the expiration date for the option.  Each contract is for 5,000bu.
  • Producers that have locked in cash sells may use call options as a re-ownership strategy to take advantage of seasonal price tendencies post-harvest.
  • The Advantages of buying calls:
    • Unlimited upside potential
    • Possible loss from the position is limited to the premium paid, therefore margin calls will not exceed the premium paid plus commissions and fees.
  • The Disadvantages of buying calls:
    • Loses value with the passage of time
      • Extrinsic value is time + volatility
    • Premiums can be expensive especially for long dated options in a volatile market or prior to report days.
  • Example:
    • A producer sells cash grain across the scale at harvest for $3.00 (-0.40 basis, Dec futures 3.40). July futures are at 3.60 and the July 3.60 call is trading for 0.25.  The producer has sold his grain but feels like the market may strengthen post-harvest.  Considering storage at .04 cents a month.  The producer has decided to sell the grain and buy calls to re-own as opposed to storing the grain to price at a later date.  The July 3.60 call less the .25 premium (plus commissions and fees) gives the producer a chance to improve prices on a July corn rally above 3.85.  If a Spring rally were to get July futures up to $4.00.  The producer has a .15 profit.

 

 

 

 

Vertical Put Spread

 

  • Definition: The vertical put spread is the purchase of a put option and the sell of a put option in the same month of exercise at different strikes.  The purchased strike is higher than the strike sold.
  • Producers looking to purchase downside protection in specific ranges of price will buy put spreads to lower the price of downside protection
  • The Advantages of buying put spreads:
    • Lower initial cost than buy puts alone.
    • Spreads help to lower the effect of changes in volatility and time decay.
    • Total loss is limited to the difference in the purchase price and sell price of the 2 options.
  • The Disadvantages of selling calls:
    • Profit potential is limited to the difference in strike prices less commissions and fees.
  • Example:
    • A producer would like to protect from price declines in the futures from $4.00 to 3.50 (which would be the approximate area revenue insurance would kick in). So the producer buys a Dec $4.00 put (0.35) and sells a Dec $3.50 put (0.15) for 0.20 less commissions and fees.  Now the producer is protected on a price break in the futures but has unlimited potential of price improvement if the market rallies.

 

 

 

 

 

 

 

Vertical Call Spread

 

  • Definition: The vertical call spread is the purchase of a call option and the sell of a call option in the same month of exercise at different strikes.  The purchased strike is lower than the strike sold.
  • Producers looking for cheaper re-ownership strategies often look at buying vertical call spreads.
  • The Advantages of buying put spreads:
    • Lower initial cost than buying calls alone.
    • Spreads help to lower the effect of changes in volatility and time decay.
    • Total loss is limited to the difference in the purchase price and sell price of the 2 options.
  • The Disadvantages of selling calls:
    • Profit potential is limited to the difference in strike prices less commissions and fees.
  • Example:
    • A producer anticipates a summer rally up to the $4.50 area and futures are currently in the upper $3’s. The producer purchases a July $4.00 call at 0.35 and sells a July $4.50 call for 0.20.  This producer is willing to risk 0.15 for the opportunity of making 0.50 cents on the trade less commission and fees.  This strategy is often cheaper than paying storage on the grain.  The position does not take advantage of basis improvements but also doesn’t suffer from grain going out of condition in the bin.

 

 

 

 

 

 

Covered Call Strategy

 

  • Definition: The owner of futures or the physical commodity sells call options to collect the premium.
  • Producers expecting to raise physical grain, may sell call options at strikes attractive for cash contracting grain at a futures date.
  • The Advantages of selling calls:
    • Collecting extrinsic value from the sell of time value and volatility.
    • Seller has the potential of collecting premium over time often used to recoup negative basis or cost of put purchases.
  • The Disadvantages of selling calls:
    • This position may be subject to margin calls and acts very much like a short futures hedge as the market rallies deeper into the money plus commissions and fees.
    • Profit potential is limited to the premium sold

 

  • Example:
    • A producer would like to sell $4.00 Dec corn futures at harvest but the market is currently at $3.60. The producer sells the $4.00 call at 0.25 cents.  At expiration if the futures are below $4.25 the position will profit up to 0.25.
      • At $3.99 futures on expiration day the producer has collected 0.25 on a call that has expired worthless. 99+0.25=4.24 futures less commissions and fees.
      • At 3.00 futures on expiration date the producer has collected 0.25 on a call that has expired worthless 3.00 +0.25=3.25futures less commissions and fees.
      • At 5.00 futures on expiration day the producer is exercised short a futures at 4.00 + 0.25= 4.25 less commission and fees.

 

 

 

 

 

Combining Strategies

 

  • The combination of buying a put spread while selling a covered call is a method of providing downside protection while leaving an upside window of opportunity for price improvement. It is often used as a lower cost method of combining strategies for a lower initiation cost.
  • The Advantages:
    • Collecting extrinsic value from the sell of time value and volatility.
    • Offers a certain amount of downside protection and upside potential at lower premiums.
  • The Disadvantages:
    • This position may be subject to margin calls and acts very much like a short futures hedge as the market rallies deeper into the money plus commissions and fees.
    • Upside improvement is limited to the strike of the call sold.
    • Downside protection is limited to the difference between the put strike bought and the put strike sold.

 

  • Example:
    • Dec futures are at $4.20. This producer would like protection against futures dropping below $4.00 to 3.50.  The producer doesn’t expect that prices will be above $4.50 at harvest.  So he buys a Dec $4.00 put (0.28) and sells a $3.50 put (0.08) and a $4.50 call (0.20) for even money.   Now the producer has 0.50 cents of downside protection in the futures with room for 0.50 upside up to the expiration period.  The premium paid is zero, but there is a margin requirement for the spread due to the short call, which may require margin calls met on a rally.

 

 

 

 

Prepared by:

Kevin Picknick

Registered broker/branch manager

A and A Trading, Kansas City KS

816-922-9643

Kevin.picknick@yahoo.com

 

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