All About Options on Futures Contracts Part 1

This is the first part of the article. Second part is available here: Part 2

All About Options for Farmers

Options are much more complicated than futures. If you do not understand futures, you will be doing yourself a disservice to read this. It will only confuse you.

Introduction

Options are traded on futures and stocks. This article is about options on futures. Get this solidly in your head:

• Call options increase in value if the futures price goes higher and lose value if the futures price goes lower.

• Put options increase in value if the futures price goes lower and decreases in value if futures price goes higher.

After you buy an option, one of three things will happen and all three are your choice. You will:

1. Sell it

2. Exercise it (exchange for a futures contract and be subject to margin calls, not always bad!)

3. Let it expire (because it is worthless on expiration day)

Lesson One Options on Commodity Futures Contracts

I am going to start using an example of real numbers:

March 2019 corn futures settled at $3.80 on Friday, October 5, 2018.

A March $3.80 call settled that same day at 15 cents.

A March $3.80 put also settled at 15 cents.

A call increases in value if the futures market price goes up (call up).

A put increases in value if the futures price goes down (put down).

If you bought a March 2019 $3.80 corn call that day, you bought the right, without the obligation, to buy March 2019 corn futures at $3.80 any business day before the option expired on the third Friday in February or:

You can sell the option at market value any business day before it expires instead of exchanging it for a futures position.

Or you can do nothing, which is what you would do if you still owned it on expiration day and it was worthless.

After you buy the March $3.80 call option, the best that can happen to you is March corn goes to $10 (or more) and you will be paid the difference between $3.80 and $10.00, or $6.20 (or more) per bushel.

If March corn is below $3.80 on the last trading, aka expiration day, the third Friday in February, no one wants to be long March corn futures at $3.80, so the call option is worthless. Thus, you lost the 15 cents plus commission of a cent or so.

If March corn is at $3.81 on expiration day, you could sell the option for one cent a bushel. Why? Because the option can (and will be) be exercised (exchanged for a March futures contract), resulting in a long futures at $3.80 with the futures at $3.81.

If March corn is at $3.94 on expiration day, you could sell the option for 14 cents a bushel because it is 14 cents in-the-money, meaning the resulting futures contract will have a profit of 14 cents. Your net on the option transaction would be a one cent loss because you paid 15 cents for the call option.

If March corn is at $4.80 on expiration day, you will receive $1 a bushel for the option if you sold it because March corn is $1 above $3.80 or it is $1 in-the-money. Your net profit would be 85 cents because you paid 15 cents for it.

In this example, the underlying futures contract is March 2019 corn.

The strike price is $3.80.

The premium was 15 cents when you bought it, but the value of the premium changes as the futures price changes. If the corn futures price goes higher, the premium goes higher and vice versa.

In this example, the day you bought the option, the premium was 15 cents, yet the option had no intrinsic value. This is the amount of profit one would have in the futures market if the option was exercised (option exchanged for a futures contract) at that moment.

If a $3.80 call is exercised, the futures position is established at the strike price, in this example, $3.80. If March corn futures happened to be exactly at $3.80 at that moment, the resulting futures position (if the option was exercised that moment) would have no profit. Thus, the call option would have no intrinsic value, because it was not in-the-money.

Yet, the premium is still 15 cents. Why? That 15 cent premium is the value the market has placed on the probability of March corn being above $3.80 when the call option expires the third Friday in February. That 15 cent premium has a time value of 15 cents and the premium of 15 cents is 100% time value, because there is no intrinsic value (no in-the-money value).

On October 5, 2018, 15 cents premium was the value the market had placed on the probability of March 2019 corn going up, and it was exactly the same value as the probability of March corn going down. That makes sense because the futures price of $3.80 was exactly the same as the strike price of both (call and put) options.

With rare exception, all in-the-money options have intrinsic value and time value. All out-of-the-money options have nointrinsic value, only time value.

On October 5, 2018, a March 2019 $3.70 corn call option had a premium of 21 cents. Since March corn futures contract was at $3.80, a $3.70 call had 10 cents of intrinsic value and 11 cents of time value (10+11 = 21 cents premium).

The longer the life of the option, the greater the time value will be. Each day that passes, the time value is diminished until the last few minutes of expiration day, at which moment the time value will go to zero. Why? There is no more time for that option to increase in value.

Another factor which impacts time value is the volatility of the underlying futures price. If corn prices are moving 10 to 15 cents up and down most days, that extreme volatility increases the probability that the option will have profit when it expires. Therefore, the premium increases. You need to know and understand that an option will have a larger time value in a volatile futures market than it will have with a quiet futures market.

The delta is the ratio of the change in the price of an option to the corresponding change in the price of the futures. For example, if a corn option has a delta of 0.60, if corn futures price changes 10 cents, the option value will change 6 cents.

Lesson Two Which strike price to buy?

There are two schools of thought on that, and they are opposite conclusions based upon the same set of facts.

For call options, the more confident you are that the futures will go higher, the lower the strike price you should buy, which will be more expensive. If you are very confident futures will go higher, investing more money in the premium for a lower strike price call will make much more money than buying a cheap, out-of-the-money call option because the delta is a much higher ratio on the lower strike price, in-the-money call option.

Generally speaking, the less confident you are the price will go higher, the higher the strike price call you should buy because you are risking less money.

But there is another consideration. If you are thinking, but not very confident, corn futures will increase, but only 20 to 30 cents in the coming two months, you will most likely be wasting your money to buy a call option out-of-the-money.

For put options, the more confident you are that the futures will go down, the higher the strike price you should buy, which will be more expensive. If you are very confident futures will go down, investing more money in the premium for a higher strike price put will make much more money than buying a cheap, out-of-the-money put option because the delta is a much higher ratio on the higher strike price, in-the-money put option.

Generally speaking, the less confident you are the futures price will go your way, the less money you should risk, so you buy an option out-of-the-money, perhaps way out-of-the-money.

Before you select a call option to buy, you must decide how high the futures price will likely go and when that high will be made. If you think $4.20 will be the top, there is not much reason to buy a $4.40 call. If you think the high will be made in June, there is not much point to buy a March or May option because they will expire before the June high.

Futures prices trade in increments (ticks) of a quarter cent. Option premiums trade in one-eighth of a cent ticks.

On Oct 5, 2018, March 2019 corn futures settled at $3.80, the following prices for March 2019 corn calls and puts were:

In the above situation:

All call options with a strike price below $3.80 are in-the-money, because if those options were exercised, the resulting futures position would have a profit.

All call options with a strike price above $3.80 are out-of-the-money, because if those options were exercised, the resulting futures position would have a loss.

All put options with a strike price below $3.80 are out-of-the-money, because if those options were exercised, the resulting futures positions would be losing money.

All put options with a strike price above $3.80 are in-the-money, because if those options were exercised, the resulting futures positions would be making money. Read the flowing sentences carefully, and think about each one until all four make sense to you.

In each case, answer the question, “If exercised, would this option create a futures position making money or losing money?”

Call options with strike prices above $3.80 are out-of-the money because futures price is $3.80.

Call options with strike prices below $3.80 are in-the money because the futures price is $3.80.

Put options with strike prices below $3.80 are out-of-the-money because the futures price is $3.80.

Put options with strike prices above $3.80 are in-the-money because the futures price is $3.80.

On January 16, 2019, March 2019 corn futures settled at $3.74.

The March $3.80 corn call settled at an even 5 cents.

The March $3.80 corn put settled at 10¾.

Only one of those options was in-the-money. Which one?

All CBOT options trade the same way.

Lesson Three Who Gets the Premium From the Option Buyer?

All we have discussed is only the purchase of options. Where does the premium go when you purchase an option? The premium goes to the trader who either sold an option he had previously purchased or the trader who wrote the option you purchased. Say what?

To you, as a buyer, it makes no difference if your premium went to a seller or a writer, but it makes a huge difference to the person receiving your premium.

An option seller is selling an option he had previously purchased. Thus, when he sold his option, he is out of the market.

An option writer is selling an option he has not previously purchased. Thus, he is getting in the market, and he is short the option. Being short, he wants the option value (premium) to go down so he can buy the same option at a lower price to offset his short position. Better yet, he wants the option to expire worthless, in which case, he keeps 100% of the option premium and the buyer of the option loses 100% of his premium investment.

The writer of an option is subject to margin calls because he is short the option and he is in-the-market. The seller of an option is not subject to margin calls because he is out-of-the-market.

If you do not understand why the following three statements are true, you need to go back to the beginning and read again. If you understand the difference between a buyer, seller, and writer of an option, then the following makes sense to you:

The buyer of an option has unlimited profit potential and limited loss potential.

The seller of an option is out of the market and has no market risk nor gain potential.

The writer of an option has unlimited loss potential and limited income potential.

Just to be clear:

Long: owner of this position makes money if the value increases

Short: owner of this position makes money if the value decreases

There are four possible option transactions:

1. Buy an option, an opening transaction (to establish a long option position), can be a call or put.

2. Write an option, an opening transaction (to establish a short option position), can be a call or put.

3. Buy an option, a closing transaction (of a previously written call or put option) to get out of the market.

4. Sell an option, a closing transaction (of a previously purchased call or put option) to get out of the market.

Option Positions:

The buyer of a call is long the futures and long a call.

A call increases in value if futures go up.

The buyer of a put is short the futures and long a put.

A put increases in value if the futures go down.

The writer of a call is short the futures and short the call.

A call decreases in value if futures go down.

The writer of a put is long the futures and short the put.

A put decreases in value if futures go up.

The seller of a call is out of the market.

One is selling a call he previously bought.

The seller of a put is out of the market.

One is selling a put he previously bought.

Ways to be long the futures with options:

Buy a call or write a put

Ways to be short the futures with options:

Buy a put or write a call

Lesson Four Which option you should purchase?

That depends on the answers to these three questions:

1) Do you expect the futures market to go up or go down?

Buy a call option if you expect the futures will go up.

Buy a put option if you expect futures to go down.

2) How high or how low to you expect the futures to go?

The strike price of your call option needs to be lower than the expected top.

The strike price of your put option needs to be higher than the expected low.

3) When do you expect the high or low to be made?

If you expect the high or low to be made in the middle of January, then you need to buy an option that will expire shortly after the middle of January to reduce your option cost and, therefore, risk.

If you expect the high or low to be made in April, then you need to buy an option that will expire no sooner than late April.

Example: you expect soybeans to make a high of $12.30 in the middle of January. So:

1) You need to buy a call option.

2) It needs to have a strike price below $12.30.

3) And it needs a life until after the middle of January (expiration date).

Take a look at the soybean options listed below.

Find the column of soybean call options.

Find the call options that will expire soon after the middle of January.

Select the call option with a strike price less than $12.30. You have many to choose from listed below, but there are many more, too many to list here. There is an option strike price every 10 cents on wheat, corn, and nearby soybean options and every 20 cents on the deferred soybean options.

So, consider how much you are willing to pay for any of those options with a strike price below $12.30. The more certain you are that soybeans will move higher by the middle of January, the more you should pay for the call. BUT: remember, the more you pay for the option, the greater your potential loss. Also, remember if you buy any option, the worst that can happen to you is you lose 100% of what you paid for the option upfront.

Options as of Close December 3, 2020

*Futures breakeven is the price the futures contract must be on expiration day for you, as a buyer of option, to recoup 100% of the premium you paid for the given option. You can sell any option during CBOT trading hours from the minute you buy it until the close of trading on the option expiration day.

The best web site I have found to clearly see all the options and everything you need to know all on one page is Woodall Risk Management at:

http://woodallriskmanagement.com/market-center/

Lesson Five Last Trading Day for Options, aka Expiration Dates of Options

All CBOT options expire the month before the underlying futures contract (example: March options expire in February) on the last Friday of the month with at least two business days the following week.

March options will always expire on the third Friday in February because February never has more than 29 days. All other months, options will expire on the third or fourth Friday of the month. You will have to look at calendar to know when a specific option expires.

In 2020, September options expired on the third Friday in August, the 21st.

In 2021, September options will expire on the fourth Friday in August, the 27th.

Don’t forget Memorial Day is the last Monday in May. If you don’t understand why I write that, read this lesson again.

Lesson Six: How Did Those March 2019 Options with a Premium of 15 cents on October 5, 2018, Turn Out? (Discussed in Lesson One)

In 2019, March options expired on February 22. March corn settled that day at $3.75¼.

Who wants be long futures at $3.80 with the futures at $3.75¼? Nobody.

Thus, $3.80 calls were worthless; the buyer of a call lost 100% of his 15 cents; the writer made the maximum amount of money possible on the transaction, 15 cents.

Who wants to be short at $3.80 if the futures are at $3.75¼? Everybody.

Thus, the $3.80 puts were worth 4¾ cents. The buyer of the put salvaged 4¾ cents of the 15 cents he paid for the put. The writer of the put made 10¼ cents. Of course, both had to pay some commission.

If you had bought the March $3.80 call at 15 cents on October 5 and did not sell it before expiration, you would have lost 15 cents because it expired out-of-the-money.

If you had bought the March $3.80 put at 15 cents on October 5 and did not sell it before expiration, you would have lost 10¼ cents because it was only 4¾ cents in-the-money at expiration.

If you had written the March $3.80 call at 15 cents on October 5 and did not buy it back before expiration, you would have made 15 cents.

If you had written the March $3.80 put at 15 cents on October 5 and did not buy it back before expiration, you would have made 10¼ cents.

Application of Options

Lesson Seven: Floor Price, Puts as the Primary Marketing Tool

Probably the most common application of puts recommended to farmers is to buy a put to provide a “floor” under the market, leaving the top side open for further gains. That is using the put as the primary safety net.

In August, 2020, I attended a meeting with two of my clients and their neighbor to discuss marketing with a commodity futures broker. The discussion covered many topics, one of which was how to lock in a floor price with options. The broker told the farmers they could buy a put to get a floor under the market.

He said, “For example, buy a $9 January put and you got your floor at $9 and unlimited upside potential.”

No, not exactly. On that day, a January $9.00 put premium (value, cost) was 18 cents. If bean prices go down and stay below $9, the put will be worth some money and will provide a floor, but that floor is not at $9.00.

The buyer of a $9.00 put has the right to be sold in the January futures at $9.00. But, if the put cost 18 cents plus one cent commission, his net futures or HTA price is $8.81 ($9.00 minus 19 cents). Include the basis, and the net cash price would possibly be less than $8 in the Dakotas or possibly $9.80 in Alabama.

If January beans are any price above $9.00 the day the farmer prices his beans, the farmer does not use the put and sells beans using the current futures price that day whether it is $9.01 or $9.86 or $15.62 or $25.32. In every case, his net selling price is reduced buy the 19 cents he paid for the put for price insurance.

Here we are on December 26, 2020, and January 2021 futures are at $12.63. So, buying a $9.00 put at any price last summer was a waste of money. However, I am sure every soybean grower that bought a $9.00 put instead of pricing his beans in August is very, very happy to lose 100% of his investment in that $9.00 put.

There is a problem with using puts for the floor price tool. Let’s say you need a net HTA value of $9.00 to keep farming another year. A $9.00 put will not do that for you, but a $9.00 HTA will.

For most of the growing season in 2020, there was a lot of doubt if soybean futures would even get to $9.00. When $9.00 was finally available in the middle of August, the carryout was much larger than it had been just thirty days earlier and twice as large as the USDA had predicted back February. Worse yet, the crop was virtually made and the USDA predicted the national average price paid to farmers for the 2020 soybean crop would be $8.35. The day in August when November beans traded to $9.03, a November $9.00 put premium was 54 cents. November soybean futures needed to get to $9.60 to be able to lock in a $9.00 floor with a put.

However, locking in a floor price for your crop has very little to do with what you or anyone else thinks the futures price will do; you are looking for protection from the price declining.

No one knows what the market will do.

If you have a high debt load, you need a floor price protection to meet your cash flow and living expense needs - no matter what anyone, including you, thinks the market will do.

A put option as a floor price is similar to a life insurance policy. If you buy a $100,000 ten-year term life insurance policy, the life of the policy (option life) will be ten years, and value of the premium (the price paid) will be determined by what the insurance company (the market) thinks is the probability you will die within the next ten years. If you do not die within ten years, the policy (option to collect, aka exercise the option) expires worthless. You wasted all that money on life insurance because you did not die! Bummer!

If you buy a put option to lock in a minimum price for your crop, you want that put option to expire worthless. Why? Because the futures price will be above the strike price of the put. You will sell your crop above the minimum price you locked in with the purchase of the put. Just as with the life insurance policy, you “wasted” money for price insurance because you sold your beans above your established floor price. How bad is that?

In 2020, how bad would it have been to buy a November $9.00 soybean put in late August for 15 cents (locking a net HTA price of $8.85) and have it expire worthless because soybean futures were at $10.83¾ on expiration

day? Would you rather sell your beans for $8.85 using your option or $10.68 not using your option?

Lesson Eight: Put Options as a Price Enhancer

I prefer to use puts as a secondary market tool, as a “price enhancer,” rather than price insurance. I recommend you use the HTA as your primary marketing tool to protect against the down side risk. You sell January beans at $9.00 on an HTA, you get $9.00 plus or minus the basis no matter where the futures are the day you deliver the beans.

Why would you sell beans at $9.00 on an HTA? Probably because you thought price would decline or perhaps because you knew you would not be able to farm the next year if this year’s beans were sold below $9.00 HTA.

But you knew when you sold HTA at $9.00, no one knows what the market is going to do and, therefore, soybean futures could go a lot higher toward the end of the year, which, of course, they did move above $12.70 in 2020.

What will bean futures do if the price of beans goes above the cost of production?

Eventually, futures prices will decline. We do not know how high the price will go, but we know someday the price of soybeans will decline below breakeven. Prices always have and always will come down.

It is an economic fact that, in a supply-and-demand market:

In the long run, the average cost of production will equal the average price received.

That economic reality is the most important thing I learned at Ohio State. I did not believe it at the time and for the next twenty years, I searched for evidence to prove it was not true, only to become convinced it is absolutely true.

That economic axiom guarantees the price of beans (corn, wheat, rice, barley, etc.) will come down sometime after the price gets above the cost of production. The higher the price gets above breakeven, the faster and further it will decline.

In the drought year of 2012, the high on December corn was $8.49 on August 10; certainly, that was cause for optimism on the surface. Many professional marketing people predicted the price of corn had reached a new plateau and would maintain a higher annual price range in the $5.50 to $7.50 range. However, that anticipation of a corn above $5.00 forevermore was cause for great pessimism for those who knew the cost of production of corn was something less than $3.75 a bushel. Fourteen months later, December 2013 corn traded down to $4.10. In May 2020 corn traded down to $3.01 on April 21, 2020, a 14-year low. Ouch!

On August 13, 2020, there was just one reason to expect soybeans to rally. The carryover was a 50-day supply, up 14 days from the projected carryover in July and up from the 27-day supply the USDA projected at its 2020 Outlook Forum in February. For the most part, the 2020 crop was made and USDA said it would be the largest bean crop ever. Brazil was going to plant more acres to beans than ever before, while US farmers were harvesting the biggest soybean crop ever. The seasonal trend was down until October 10,, and futures prices were up against the technical resistance of the 200-day moving average, a level that had kept a lid on soybean prices since January 24.

Market advisors recommended farmers contract a huge amount of beans at $9.00. I was surprised when I called a very market-savvy client to recommend he price beans, he said, “I already did a few days ago.”

What was the one and only reason to expect soybeans price to rally above $9.00 in August 2020? Soybean prices had been below the cost of production for more than two years!

Three months and ten days later, January beans traded to $12.00. Here at Christmas, January beans are $12.63.

Those who sold beans at $9, left $3.60 on the table, with no chance to collect any of that $3.60, right? Wrong!

The best cure for high prices is high prices because high prices encourage production and discourage consumption. Instead of Brazil planting its traditional 2 to 3% more acres of beans for their 2021 harvest, it is estimated (as of mid-December 2020) Brazil’s farmers planted 4+% more acres of beans than a year ago. With beans at a six-year high and corn at a seventeen-month high, what will the market expect US farmers to plant in 2021? Broiler egg set has been running 2% less than a year ago for months. Cattle on feed numbers are in sharp decline month-to-month. US hog numbers have not expanded for six months. The soybean crush margin declined from $2.32 on November 5 to $1.69 on December 10 and to $1.34 by mid-January

With more or less normal weather in Brazil and the Corn Belt in 2021, soybean prices will decline to near or below $9.00 in 2021.

How to make some of that $3.50 left on the table by those who sold beans at $9.00 back in August?

There are two ways.

1) Short the futures. The problem with that is Brazil’s weather could turn really nasty in January, and soybean futures go to $17.89 like they did in 2012. Let’s see, if bean futures are sold at $12 and they go to $17, that would be… wow! $5 per bushel of margin money. Can you afford to take the risk of coming up with the cash to fund $5 on every bushel you grew in 2020 and will grow in 2021? Even if I could afford it, I sure would not want to do that.

2) Buy a put. A July 2021 soybean $11.60 put can be bought for less than 30 cents a bushel. If July beans trade down to $10.00 by June 25, the $11 put will be worth $1.60. If the July beans trade down to $9.00, the $11.60 put will be worth more than $2.60. Add $2.00 put transaction profit to the $9.00 HTA price and suddenly, you have a $11.00 net HTA price with the top at $12.60 and the security of having a floor locked in at 9.00 back in August.

What if beans go to $18 due to drought in Brazil? You may not recover your 30 cents you paid for the $11.60 July put, but if soybeans are $18 in February, how many acres of beans will US farmers plant? What will demand for bean meal and bean oil do? Right.

So, you buy a September soybean $17 put for 25 cents. If bean futures are anything above $9 when that option expires, you buy another put for 25 cents with maturity into 2022 until the downtrend is over. If you buy a put for 25 cents, the worst that will happen to you is you will lose 25 cents. Pay the 25 cents upfront and no margin calls, no matter how high beans go.

There is no good reason not to do that if futures go that much above breakeven.

In 2012, soybean futures declined more than $4 in two months and two days after the $17.89 high was made. Two years and three weeks after the 2012 high was made, soybean futures traded at $9.00.

No one knows, certainly not me, how high beans will go in 2021, but I know sooner or later, bean prices will go below $9.00 again.

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