Aplications Using Options

Agricultural Economics Rpt. No.
200
May 1985
Commercial and Producer Applications Using

Options on Grain Futures
by
John P. Satrom
Alfred K. Chan
William W. Wilson
Department of Agricultural Economics

Agricultural Experiment Station
North Dakota State University
Fargo, North Dakota 58105
Highlights
Trading of options on agricultural commodity futures began on an
experimental basis in October 1984.
This report provides a brief descrip-
tion on use of options by merchants and producers.
The advantage of using
options is their ability to lock in a floor or ceiling price for the

underlying future, allowing the merchant or producer to take advantage of
favorable price movements.
To do so, the hedger pays a premium.
In this
sense options are analogous to price insurance whereby a premium is paid to

protect against an adverse movement in prices.
Options can be viewed as an innovation or new technology in the
marketing system. They can be used for a multitude of purposes including
hedging long and short cash positions, forward contracting, as well as
speculating.
In many cases options are more appropriate hedging vehicles
when quantity or yield risk is present.
Mechanics and examples of each of
these applications are presented in this publication.
TABLE OF CONTENTS
Page
List of Tables . . . . . . . . . . . . . . . .. .. ..
. ..... .
List of Examples . . . . . . . . . . . . . . . . . . . .. . . . ..
List of Figures
ii
.
ii
. . . . . . . . . . . . . . . . . . . . . . . . . .. 1i
Commodity Options: Introduction ...................

...........
.......................
History . .
.
. . ... . . . . . .
.
.
.
.
Definitions . . . . . . . . . . . .
Simple Mechanics of Option Trading . ...............
Buying Puts . . . . . . . . . . . . . . . . . . . .. . .. . .
Buying Calls . . . . . . . . . . . . . . . . . . . . . . . .. .
Selling Puts . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling Calls . ................ . . . . .. . .
Summary on Use of Options Versus Futures . ............
1
1
2
3
4
4
5
5
6
8
Application of Options by Merchants ................
.............. 8
Long Cash . . . . . . . . . . . ........
9
Long Cash/Long Puts . . . . . . . . . . . . . . . . . . . .
10
Long Cash/Short Calls . ............... . . ..
11
Summary of Long Cash Position ................. ..
. . 11
Short Cash .............. .... . . . . . . .. ..
.. 13
Short Cash/Long Calls .............. . . .
14
.
.
................
Puts
Short Cash/Short
.
15
.
.
.............
..
Position
Summary of Short Cash
17
.
.........
.
Prices
Ceiling
and
Floor
Forward Contracts with
17
.
Forward Contracts with Floor Prices . .............
19
.
.
............
Prices
Forward Contracts with Ceiling
.
21
.
Summary of Forward Contracts . ...............
.22
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.
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.
.
Quantity Risk ................
. .. .. . 22
Overnight Transactions . ..............
.. 25
Summary of Quantity Risk . .............. . . .
26
.
Selected Decisions to be Made in the Use of Options . ........
Terminating Option Positions . ............... . . 26
In-the-Money Vs. Out-of-the-Money Options . ............ 27
27
.
Long Cash/Long Puts . ............... . ..., ....
Short Cash/Long Calls . ......... .... . . . . . . .. 30
31
. . .. . . ..
Summary of Options .. . ..............
. . .
Pricing of Commodity Options . ...............
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Concept . .
. . ...........
........... . ..
Length of Time . .
. . . . . .
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..
.
........
Market Volatility
. . . . . .
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.
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.
..
.
.
Interest Rates .........
........
.
Price
Strike
and
Relationships Between Market
. ........
Black/Scholes Pricing Model . . . . . . . . . . . .
. . . . .
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Delta Factor . . . . . . . . . .
. . . . .
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Recent Premiums . . . . . . . . . . . . .
Summary
. ....................
Selected Bibliography
. ......
..
33
33
33
34
.
36
..
. . 36
38
41
..
. . 41
43
44
List of Tables
Table
No.
Pag
MERCHANT CASH POSITIONS AND USE OF FUTURES AND OPTIONS . . . .
OUTCOME OF A CHANGE IN FUTURES PRICES ON LONG ITM AND OTM

POSITIONS ..
. . . ............
. ....
31
OPTION PREMIUMS FOR VARIABLE MATURITIES
OPTION PREMIUMS FOR DIFFERENT LEVELS OF MARKET VOLATILITY
OPTION PREMIUMS FOR VARIABLE INTEREST RATE ..........
37
OPTION PREMIUMS FOR VARIABLE STRIKE PRICE
37
INTRINSIC AND EXTRINSIC VALVE FOR DIFFERENT STRIKE PRICES OF

CALL OPTIONS ................... ...
.. ... . .
.... .34
.
36
..........
OPTION PREMIUMS AND DELTA COMPUTED FROM BLACK/SCHOLES MODEL
FUTURES AND OPTION PRICES: MINNEAPOLIS WHEAT AND CHICAGO

SOYBEANS, NOVEMBER 1984 TO FEBRUARY 1985 . ........
38
.
40
42
List of Examples
Example
No.
Page
LONG CASH/LONG PUTS
LONG CASH/SHORT CALLS
... .
SHORT CASH/LONG CALLS
.................
SHORT CASH/SHORT PUTS
. .................. . .
DERIVATION OF FORWARD CONTRACTS (I.E., PRODUCERS WITH PRICE

FLOOR . . . . . . . . . . . . . . . . . . . . . . . . . ..
...........
. .....
.. . . .10
................
12
.. .14
16
18
DERIVATION OF FORWARD CONTRACTS FOR SALE (E.G., TO IMPORTERS)

WITH PRICE CEILING
. ............
.....
OVERNIGHT SALE TRANSACTION . .................
OVERNIGHT PURCHASE TRANSACTION . ..........
- ii
. . 20
23
. . . ..
24
COMMERCIAL AND PRODUCER APPLICATIONS USING

OPTIONS ON GRAIN FUTURES
John Satrom, Alfred Chan, and William Wilson*
Commodity Options:
Introduction
History
Commodity options have had a history of adversity and diversity.
Grain options began trading on the Chicago Board of Trade as early as the
Civil War. Shortly after their introduction, however, the Board of Trade
tried to cease trading because of perceived abuses. The state of Illinois
banned option trading both on and off exchanges, but trading continued
despite this statutory ban. Further restrictions came in 1887 when the
Board of Trade found it necessary to restrict option trading by its
members. Agricultural options were then alternately traded and banned
between 1887 and 1936. In 1936, Congress banned the trading of
agricultural options completely with the Commodity Exchange Act of 1936.
A number of factors caused the 1936 ban, including the following:
options were not being used for traditional risk-shifting purposes, small
traders "lured" into options markets to speculate usually lost money, large
traders could use options to cause artificial price movements, terms and
conditions of options were not standardized, and congestion near the close
of the market could occur because many options were good for less than a
day (Horner and Moriority 1983). A specific case occurred in the early
1930s when options were blamed for the excessive price movements in wheat,
which led to the collapse of the Chicago Board of Trade's wheat market in
1933. Trouble continued to occur in the late 1960s and early 1970s when
gold options were being sold fraudulently.
The problems all seemed to stem from the lack of one specific
governing body. After the gold incident, the Commodity Futures Trading
Commission (CFTC) was given full control of all commodity futures and
options trading. The commission has worked to develop regulations for
exchange-traded options, and in September 1981 the CFTC approved a threeyear pilot program including options trading in gold, treasury bonds, and
sugar. Following this, the Futures Trading Act of 1982 lifted the 1936 ban
on agricultural options. The result was development of an experimental
three-year program of organized trading in selected agricultural options
which was introduced in October 1984.
*Satrom and Chan are graduate research assistants and Wilson is
associate professor, Department of Agricultural Economics, North Dakota
State University, Fargo.
- 2
Agricultural options provide a risk management alternative for most
participants in the agricultural marketing chain. This report examines the
salient features of agricultural options as applied to merchandisers (i.e.,
elevators, domestic merchants, and exporters) and producers. Topics
discussed include simple mechanics of options, specific applications,
discussion of selected option details, and option pricing. The treatment
is not exhaustive and additional references are listed at the end of the
text. Definitions for the unique terminology are listed below and used
throughout the text.
Definitions
An option is a contingent contract between two parties to buy or sell
a particular "underlying" commodity under specific conditions. Additional
basic definitions and relationships associated with agricultural options
follow:
Call Option - An option which gives the buyer the right, but not the
obligation, to purchase (go "long") the underlying
futures contract at the strike or exercise price on or
before the expiration date.
Put Option
- An option which gives the buyer the right, but not the
obligation, to sell (go "short") the underlying futures
contract at the strike or exercise price on or before
the expiration date.
Premium
- Option buyers pay a negotiated cash premium to the

option seller in return for the rights associated with
holding the option. This premium or option price is
determined competitively in the trading pit in an
auction-like manner. The premium consists of two
components: intrinsic value and extrinsic or time
value.
Strike or
Exercise
Price
- The price at which a call (put) option holder may buy

(sell) and a call (put) option writer is required to
sell (buy) on the holder's demand. Exercise prices are
established at regular intervals above and below the
current futures price.
In-the-Money- A call (put) is in-the-money if its strike price is

below (above) the current price of the underlying
futures contract.
At-the-Money- An option, call or put, whose strike price is equal-or approximately equal--to the current market price of
the underlying futures contract.
- 3Out-of-theMoney
- A call (put) is out-of-the-money if its strike price is
above (below) the current price of the underlying
futures contract. The option, call or put, has no
intrinsic value.
Intrinsic
Value
Time or
Extrinsic
Value
- A component of the option premium which is measured in

a dollar amount (if any) by which the current market
price of the underlying futures contract is above the
strike price for the call option and below the strike
price for the put option. Both at-the-money and
out-of-the-money options have no intrinsic value.
- Another component of an option premium, measured by the

amount by which the premium exceeds the intrinsic value
of the option.
Expiration
Date
Breakeven
Level
Time Value = Premium - Intrinsic Value
- The date that is the last day that a holder of a put or

call option may "exercise" his or her right to buy or
sell the underlying futures contract at the option
strike price. After the expiration date, the option
contract becomes null and void. The expiration dates
will parallel futures contract months. For example, a
September spring wheat option on a September spring
wheat futures contract will expire at least ten days
prior to the first notice day of the September futures
contract.
- There is a separate breakeven level for both call and
put options. For the call option, the breakeven level
equals the strike price plus the premium. For the put
option, the breakeven level equals the strike price
minus the premium.
Simple Mechanics of Option Trading
Merchandisers and, to a lesser extent, producers are familiar with

the advantages of hedging with commodity futures. The development of
options will in some cases complement and in others substitute for futures
hedges, depending on the individual's risk aversion and potential return.
The primary difference between options and futures for hedging purposes
deals with the price that is locked in. A futures hedge allows the hedger
to lock in a specific price for the futures, while use of options locks in
a floor or ceiling price for the futures. An uncovered cash position is
characterized by having the potential for high risk and, at the same time,
large returns. When a futures position is taken opposite to the cash position, the hedger offsets potential cash market losses but can also negate
any cash market gain.
-4With the use of options, losses in the cash market are offset by
gains in the option market but gains in the cash market are not negated by
losses in the futures or options. There are four basic positions in option
trading: buying puts, buying calls, selling puts, and selling calls. It
should be noted that puts do not offset calls and vice versa; each is a
separate type of option. Each option position depends on the user's cash
position along with other factors specific to each merchant. A long option
position involves limited risk and potentially large returns. Conversely,
a short option position, or selling options, entails potentially large
risks and limited returns.
Buying Puts
A hedger with a long cash position can establish a floor price and be
able to take advantage of a price rise by having a long put position. The
only cost involved is the premium paid by the purchaser to the seller at
the time the transaction is initiated. The following example will help
illustrate this. A long cash grain position is taken at a futures price
which would realize a small profit. The merchant or producer is optimistic
about prices in the future, yet he would like to lock in this price as a
floor, resulting in a small profit over operating costs. The appropriate
action in the option market would be to buy puts. This allows the merchandiser to lock in a floor price equal to the strike price minus the premium.
The basic idea behind this plan is that if prices decline further, the
option may be exercised to obtain the floor price. Exercising the put
options involves assuming a short futures position at the strike price when
their actual value is less than the strike price. The difference between
the two prices minus the premium would be the net profit. Alternatively,
if the underlying futures price rises, the puts will not be exercised; the
effective price will be the higher cash price minus the premium.
Buying Calls
A long call position allows a hedger to establish a ceiling price
while being able to benefit from a price decline. A short cash grain position can be protected by purchasing call options. Once again, the only
cost incurred is the premium. A number of different scenarios can be developed to illustrate a short cash position; in some cases price risk will be
prevalent and in others quantity risk may be apparent. Specific examples
of each will be given later. An illustration of a short cash position will
demonstrate the simple mechanics of a long call position.
For instance, a merchandiser (or processor) who has sold cash grain
for future delivery but does not have the physical commodity on hand is
subject to the risk of a price increase before actually buying or pricing
the grain. The merchant could hedge in the futures market but would not
be able to benefit if prices declined. Purchasing calls would lock in a
ceiling price equal to the strike price, plus, if prices increased, the
merchant would be able to realize the ceiling price by exercising the call
option. This would entail assuming a long futures position at the strike
price when actual value is greater; the difference between the two prices
- 5less the premium will be the net profit. Conversely, if prices fell, the
calls would not be exercised; the effective purchase price would be the
cash price plus the premium.
Selling Puts
Long option contracts are analogous to buying price insurance, with
the cost of the insurance being the premium. Selling option contracts can
then be thought of as selling or writing price insurance. The option
writer, or seller, receives a premium in return for issuing the insurance.
Consequently, the option seller may be able to augment his income by the
amount of the premium. However, the seller must also be prepared to face
margin requirements and the possibility of a mandatory futures position if
prices move against him.
A merchant with a short cash or forward position could sell puts with
the intention of increasing income by the amount of the premium. This
alternative is attractive only if price expectations are bullish or
neutral, because if prices decline, the futures position may be assumed at
a loss. This is the negative aspect of selling puts. The level of gain
from such a strategy is fixed while the amount of loss is unlimited. The
primary decision criteria for selling puts is the premium value, or the
maximum amount that can be added to income.
The basic mechanics of selling puts to increase income are relatively
easy to understand. The merchant begins with a short cash position as
mentioned earlier. He is bullish about the future and feels that premiums
are high enough to support selling put options. The merchandiser receives
the premium right away, but he must also comply with margin requirements.
If prices go up sufficiently, the puts are not exercised by the buyer, and
the merchant gains the premium. If prices go down, the options.may be
exercised, and the merchant will be assigned a long futures position at the
strike price.
In addition to augmenting income, selling of puts can be used to
acquire commodity futures at a price below the current market price. This
will occur if the put is exercised by the buyer; the put writer is then
obligated to acquire a long futures position. The effective price paid for
the futures will be the put strike price less the premium received. This
type of strategy may be beneficial to a merchant, such as a grain
processor whose product price is fixed and who wants to protect his profit
margin. Selling puts offsets an increase in grain prices by the amount of
the premium and at the same time establishes a floor price for the purchase
of the grain should prices decline. It should be noted that if prices do
decline and the puts are exercised, the put writer can immediately offset
his long futures position by selling futures for the same delivery month.
Selling Calls
The fourth basic option position is selling calls. This strategy may
be used by a commercial merchant or producer who has a long cash position.
- 6 -
A short call position would be taken if he had essentially bearish or

neutral expectations about the particular grain market. Like selling puts,
selling calls gives the merchant the opportunity to increase current income
or margins by the amount of the premium.
The scenario under which calls may be sold is basically when a
merchant has a long cash position and expects the market to be bearish or
neutral, as mentioned above. When the merchant sells the calls, the premium is earned. Once again, he must also face margin requirements,
including possible margin calls if the options are exercised and prices
move against him. If, however, prices fall or remain at approximately the
same level over the life of the contract, the calls will expire.
Consequently, the merchandiser will be successful in increasing income by
the option premium less depreciation if the physical grain was being
stored.
If prices appreciate significantly during the life of the option, the
calls would be exercised. This would result in the merchant being obligated to take a short futures position at the strike price when they are
actually valued higher. The difference between these two prices plus the
premium would result in the net loss. If the physical grain were being
stored, the merchant would also realize an appreciation in the value of the
inventory. Thus, a ceiling price would be locked in for the commodity.
Summary on Use of Options Versus Futures
Options and futures are inherently related. This is evident by the
fact that, like futures, there are two basic option transactions which can
be initiated. One is to purchase options and the other is to sell or write
options. The specific direction will be determined by the user's main
objective. If he wants to lock in a floor or ceiling price, the
appropriate action would be to buy options. The primary characteristic of
this strategy is unlimited profit potential with the only cost being the
premium. Alternatively, if his goal is to increase income, options can be
sold. However, there would be unlimited risk of an adverse price move,
while the gain would be limited to the premium. Therefore, the risks are
greater and the potential return smaller with a short options hedge relative to a long options hedge.
Table 1 summarizes the characteristics of options versus futures
hedges for producers and merchants with long and short cash positions.
Typically, a long cash position could be hedged in the futures market by
selling futures contracts. This requires margin money and, in addition,
locks in the sale price so futures prevents the hedger from benefiting from
a price increase. However, a long cash position could also be hedged in
the options market either by purchasing puts or selling calls. Buying puts
allows the user to lock in a floor price equal to the strike price minus
the premium. Selling calls results in an increase in income by the amount
of the premium, although margin money is required and unlimited risk of a
price decrease is realized. In addition, if the underlying futures price
increases so that the calls are exercised, the seller will be obligated to
take a short futures position at the strike price when they are actually
valued higher.
- 7-
TABLE 1.
MERCHANT CASH POSITIONS AND USE OF FUTURES AND OPTIONS
Cash Position
Traditional Futures Positions
Alternative Option Positions
Long Cash
Sell Futures
Buy Puts
(Inventory
or Forward
Purchase)
- requires margin
- protects against price
decrease
- cannot benefit from price
increase
- locks in floor price

-.benefit from price
increase
- must pay premium
- no margin
Sell Calls
- increase income by
amount of premium
- requires margin
- unlimited risk of price
decrease
- possibility of having
short futures if
exercised
Short Cash
Buys Futures
- requires margin
- protects against price
increase
- cannot benefit from price
decrease
Buy Calls
- locks in ceiling price
- benefit from price
decrease
- must pay premium
- no margin
Sell Puts
- increase income by
amount of premium
- requires margin
- unlimited risk of price
increase
- possibility of having
long futures position

if exercised
Conversely, a short cash position is traditionally hedged in the
futures market by purchasing futures contracts. Once again, this locks in
a price so the hedger is not able to benefit from a price decrease, while
-8also requiring margin money. Alternatively, this cash position could be

hedged in the options market by one of two ways: buying calls or selling
puts. Buying calls locks in a ceiling price. Selling puts increases
income by the premium but requires margin money and exposes the hedger to
unlimited risk of a price increase. However, if prices decline significantly and if the puts are exercised, the seller will be required to take a
long futures position at the strike price when they are actually valued
lower.
Application of Options by Merchants and Producers
Traditionally, elevators, domestic merchants and exporters have made
extensive use of the futures market in hedging cash positions. Producers
hold similar cash positions and the same principles apply. The options
market can be used by any of these participants as a substitute and/or
supplement to the futures market in the hedging role. Each of these participants performs unique functions in the grain marketing chain. However,
they are homogeneous in the sense that they can have similar cash positions. This allows for generalizations across merchants and producers
about the type of option position to use for a specific cash position. A
number of assumptions are used in each of the examples and are listed
below. Assumptions used in all examples:
- The purchase or sale of an option will be made at a strike price
which is at-the-money.
- Premiums are based on Black/Scholes model calculations and are
representative for example purposes.
- Options contracts are liquidated or offset in each case instead of
exercising or letting them expire.
- There will be no change in the basis. This is assumed to
demonstrate the mechanics and isolate the effects of changes in
cash futures and option values. There will always be some basis
risk, and options do not protect against basis risk.
Long Cash
For a merchant with a long cash position, the greatest risk is the
price risk associated with the sale of that grain. A producer has similar
risk when planting decisions are made. The only difference between a producer's and merchant's cash position is that before harvest the producer
also has an element of risk associated with production (i.e., yield risk).
Both participants have a desire to protect the value of their cash market
position. When the futures market is used, a futures price is locked in,
thereby minimizing risk. However, they would be unable to benefit if
futures prices increase after the futures position is taken. This is where
an options contract would be desirable. As demonstrated in Table 1,
merchants or producers with long cash positions can either buy puts or sell
calls. Examples of each are described below.
-9Long Cash/Long Puts:

A merchant or producer with a long cash position who wants protection
against a bearish price move could lock in a floor price but also
benefit from a potential price rise by purchasing put options. The
buyer must decide whether to buy in-the-money (ITM), at-the-money
(ATM), or out-of-the-money (OTM) puts, although we are assuming ATM
in this case (the differences will be discussed in greater detail
later). The premium will vary for each case as will the final
results.
A long put position gives the buyer the right but not the obligation
to sell futures at a specified strike price or exercise the option.
However, instead of either exercising or letting the option expire,
the buyer may also offset his position by selling the puts back. The
price movement of the underlying futures price will affect the
buyer's decision. If the underlying futures price increased significantly over the life of the option, the buyer could then either let
it expire and realize the greater price or sell the puts back and
possibly earn a premium plus the higher cash price.
If the opposite occurred, that is, the underlying futures price
dropped considerably, the buyer could again pick one of two possibilities: exercise the option and be given a short futures position at
the strike price, or offset the option, receive a premium, and be out
of the futures market completely. In either case, the risk is
limited to the premium paid while the possible returns are unlimited.
The mechanics of this type of transaction are best illustrated in
Example 1.
Example 1 illustrates that the largest net result occurs when the
underlying futures price increases. It should be noted that the
premium earned on the liquidation of the puts is equal to zero
because there is no intrinsic or extrinsic value left in the option.
Conversely, when the underlying futures price declines, the intrinsic
value of the puts increases and results in the greater premium being
earned from offsetting the position. However, the net result is
still a negative figure because the intrinsic value did not increase
enough to cover both the cash loss and the original premium. Thus,
the returns have unlimited upside potential while the largest loss is
limited to the premium.
A traditional hedge against a long cash position would be to sell
futures. In Example 1, because the basis is assumed unchanged, the
net result would be zero and the effective sales price would be 410.
Thus, if prices increase an options position is preferable to a
futures hedge, and vice versa for price decreases.
- 10 -
EXAMPLE 1. LONG CASH/LONG PUTS
Setting:
September 3, 1984
Buy 20,000 Bushels
December Futures
Duluth Basis
December 380 Put
@410
380?
30O
8?
A. Sell cash on November 1 at which time December futures increased

to 4209. (Basis is unchanged at +30).)
1. Sell (offset) put, or let expire
2. Calculation of returns
Return from cash sale
Less purchase price
450?
-410
Less premium paid
Plus premium earned
Net Result
+ 329
Effective Sale Price
442?
B. Sell cash on November 1 at which time December futures decreased

to 350.
(Basis is unchanged at +30.)
1. Could exercise option, or sell (offset) put
Less purchase price
380?
-410
Less premium paid
Plus premium earned
+ 30
Net Result
Effective Sale Price
8
8
402?
Long Cash/Short Calls:

Another tactic for a merchant or producer with a long cash position
is to sell call options. A short call position allows the seller to
augment current income by the amount of the premium. This course of
action is especially attractive if prices are expected to remain
relatively stable.
- 11
Once again, the ITM, ATM, or OTM calls can be sold, but it is
assumed that ATM calls are used. In this case, the seller receives
the premium at the time of the sale. The return is limited to this
premium while potential losses are unlimited. Margin money is also
required to cover a potential futures position. A short call position does not offer the seller many alternatives in regard to a price
increase or decrease. The only choice is between holding the call
position with the results determined by the actions of the buyer or
buying the calls back before they are exercised or expire. If the
underlying futures price increases, the buyer may exercise the calls,
in which case the seller will be given a short futures position or
the seller can offset the calls before they are exercised to ensure
staying out of the futures market. However, the seller must remember
that if he offsets the options, he will have to pay a premium. If
the opposite occurs where futures prices decrease, the buyer will
most likely not exercise the calls because the price move is
favorable. The seller can then buy the options back any time before
expiration if desired, or he could simply let them expire without
liquidating. Example 2 illustrates the mechanics of this type of
transaction when the options are offset.
It is evident from this example that the greatest possible net return
is limited to the premium earned from the call sale, which in this
case is 8 cents. Furthermore, the seller's risk is theoretically
unlimited. When the futures price did decline and the calls were
offset, the premium paid was equal to zero because the option had no
intrinsic or extrinsic value left. However, in Part A where the
futures price increased, the options gained intrinsic value and thus
resulted in the 40-cent premium paid for offsetting the calls.
Therefore, selling call options with the intention of later
liquidating this position is risky and is beneficial only when
futures prices remain relatively stable or increase.
Summary of Long Cash Position
A merchant or producer with a long cash position has two option
alternatives: to buy puts to lock in a floor price, or to sell calls to
supplement current income. An important difference between the two choices
is the risk levels involved. Buying puts is preferable to traditional
hedging if futures prices increase because the gain in cash prices is not
offset by losses in the futures. A long put position results in limited
risk and unlimited profit potential, while a short call position is characterized by a return limited to the premium and risk that is theoretically
unlimited. Thus, in most hedging applications, buying puts will be more
advantageous than selling calls.
Short Cash
Another typical position of grain merchants, processors, and to a
lesser extent producers, is to be short cash grain. If a futures market
is used as a hedge, the purchase price is locked in so long as the basis is
- 12 -
EXAMPLE 2.
Setting:
LONG CASH/SHORT CALL
September 3, 1984
Buy 20,000 Bushels
December Futures
@410
380?
Basis
December 380 Call
30%
8?
A. Sell cash on November 1 at which time December futures increased

to 420.
(Basis is unchanged at +30%.)
1. Buyer may exercise calls, or seller may offset (buy back)
the call
Less purchase price
450?
-410
Option premium earned

Less premium paid
+ 8
- 40
Net Result
Effective Sales Price
8?
418?
*Loss in option is offset by gain in cash value.

B. Sell cash on November 1 at which time December futures decreased
to 350. (Basis is unchanged at +309.)
1. Option will not be exercised by purchaser
Less purchase price
380?
-410
Option premium earned
Less premium paid
Net Result
- 22?
Effective Sales Price
388?
unchanged. However, the merchant is unable to take advantage of a decrease

in prices after the contract is made. An options hedge, on the other hand,
permits the buyer to benefit from a price decline.
- 13 -
A merchandiser with a short cash position would ultimately like to

establish a ceiling price and take advantage of a fall in prices. A common
scenario is for a merchant or processor to sell grain for some future month
but not have the physical grain on hand. Purchasing call options would
establish a ceiling price for the eventual cash purchase. Merchants can
either buy calls or sell puts against a short cash position. The following
examples illustrate the mechanics involved and possible outcomes. Like the
first examples, the same assumptions apply.
Short Cash/Long Calls:
A merchant or producer with a short cash position who wants to protect against a bullish price move and benefit from a potential price
decline could lock in a ceiling price by purchasing call options. It
is assumed that ATM calls are bought, although ITM or OTM calls are
also possible. The buyer pays a premium for the privilege to lock in
the ceiling price.
The long call position gives the buyer the right but not the
obligation to buy futures at the strike price or to exercise the call
option. Two more alternatives still exist: he could let the options
expire or offset his position by selling the calls back. The
decision depends on the movement of the underlying futures price.
If the underlying futures price increased significantly, the merchant
could exercise the options in which case he would receive a long
futures position at the strike price when the futures value is
actually greater. Alternatively, the buyer could liquidate his
option position, gain a premium, and be clear of the futures market.
If the futures price declined substantially, the buyer could either
let it expire and realize the lower price, or offset the calls to
possibly.gain a premium. Furthermore, because the futures price
declined, the purchase price will also be less. Example 3
illustrates the mechanics of this type of transaction.
This example shows that the greatest loss is limited to the premium
paid while the potential returns are virtually unlimited. When the
underlying futures price increased, the net result was a loss of 8
cents--the premium. The premium earned from the liquidation of the
calls just offset the larger purchase price because the intrinsic
value of the calls had increased. Conversely, in Part B the premium
earned equalled zero because there was no intrinsic or extrinsic
value left. The net result is greater in Part B because of the
lower purchase price.
Buying calls is preferable to traditional hedging if futures prices
decrease because the gain in the cash price is not offset by losses
in the futures. If futures prices increase, buying futures yields a
greater return by the cost of the premium.
- 14 -
EXAMPLE 3.
Setting:
SHORT CASH/LONG CALLS

September 3, 1984
Sell 20,000 Bushels

December Futures
@410
380?
Basis
December 380 Call
30%
8?
A. Buy cash on November 1 at which time December futures increased

to 420%.
1. Option can be exercised, or sold to offset
410?
-450
Less purchase price
- 8
Less premium paid
40
Plus premium earned
Net Result
Effective Purhcase Price
8?
418?
B. Buy cash on November 1 at which time December futures decreased

to 350%.
1. Option could be left to expire, or offset
Less purchase price
410o
-380
Less premium paid
Plus premium earned
Net Result
+ 22%
Effective Purchase Price
388?
Short Cash/Short Puts:

Buying call options is not the only strategy for a merchant or producer with a short cash position. Put options could also be sold.
This alternative does not lock in a ceiling price, however. Instead,
it either offers a chance for the merchant to increase his current
income or buy futures at a lower price if the options are exercised.
The best outcome will occur if the market remains relatively stable
- 15 -
so that the options will not be exercised, but yet retain some
intrinsic value. Furthermore, the results will vary depending on
whether the merchant sells ITM, ATM, or OTM puts; however, ATM puts
will be assumed sold. Selling puts will produce a limited return
equal to the premium while the risk potential will be unlimited. In
addition, the merchant will be required to have margin money
available.
Overall, a short put position has virtually the same fundamental
characteristics as a short call position. The seller can only choose
between liquidating his position before the puts are exercised or
waiting for the buyer's actions. If the underlying futures price
increases, the buyer would likely let the options expire because he
wants the highest possible price. The seller then can decide.whether
buying the puts back or letting them expire will result in higher
returns. If the futures price decreases, the buyer would probably
exercise the puts, resulting in the seller's assuming a long futures
position at the strike price. However, the seller could also buy the
puts back before they are exercised to alleviate entering the futures
market. The procedures and outcomes involved in a short cash/short
put position when the futures price increases and decreases are
illustrated in Example 4. The option position will be offset in both
instances to insure consistency with previous examples.
Part B of Example 4 shows that a positive return occurs when the
underlying futures price decreases, and this return is equal to the
premium of 8 cents. The merchant paid 30 cents to buy the puts back
because of the gain in intrinsic value. In contrast, the cost of
liquidating the short put position in Part A was risky because the
option had no intrinsic or extrinsic value remaining. It is obvious
that the reason the net result was negative in Part A was because of
the greater cash purchase price. However, if options had not been
used at all, the net result would have been -40 cents. Conversely,
the outcome in Part B was positive because of the smaller cash price.
Thus, a merchant selling put options with the intention of later
buying them back accepts a theoretically unlimited amount of risk,
while the return is limited to the premium. The premium can only be
realized if the futures price remains relatively stable or decreases,
however.
Summary of Short Cash Position
The last two examples have shown that a merchant or producer with a
short cash position has two basic option strategies to choose from,
depending on his objectives. If his main objective is to lock in a ceiling
price on the purchase of the grain, call options should be bought. This
tactic also permits the merchant to benefit from a decline in grain prices.
Buying call options is preferable to traditional hedging, i.e., buying
futures, if futures prices subsequently decline.
If the main goal is to augment current income or margins, and prices
are expected to be relatively neutral or slightly bearish, put options
- 16 -
EXAMPLE 4.
Setting:
SHORT CASH/SHORT PUTS
September 3, 1984
Sell 20,000 Bushels
December Futures
@410
380?
Basis
December 380 Call
30%
8?
A. Buy cash on November 1 at which time December futures increased

to 420%.
1. Option could be left to expire, or offset by seller
410?
-450
Less purchase price
8
Premium received
(Sept. 1)
Less purchase of put
0
Net Result
- 32%
442?
B. Buy cash on November 1 at which time December futures decreased

to 350%.
1. Buyer may exercise option, or seller may offset (buy back)
Less purchase price
Premium received
410?
-380
8
Less purchase of put
- 30
Net Result
8?
402?
should be sold. The disadvantage of this procedure is that if prices

decrease and the options are exercised before they are offset, the seller
will be required to take a long futures position at the strike price when
the actual value is less. Again, the greatest difference between buying
calls and selling puts is the risk level involved. Purchasing calls
results in a limited risk (the premium) and unlimited returns. Selling
puts, on the other hand, is characterized by theoretically unlimited risk,
with only limited returns (the premium).
- 17 -
Forward Contracts With Floor and Ceiling Prices

The options market has the possibility of giving a new dimension to
forward contracts. Typically, forward contracts have been made by
elevators to producers, by exporters to importers and by merchants to
processors. In the past, these types of contracts have been implemented
via the futures market. The result has been a forward contract with a
fixed price. The disadvantage of this situation is that a producer would
be unable to benefit from a rise in prices or an importer unable to take
advantage of a fall in prices. Agricultural options stand to change this
scenario by making forward contracts more attractive to producers and end
users.
Merchants can offer a forward contract with a floor or ceiling price
by incorporating the use of options. The logic behind this plan is easy to
understand because it follows from previous examples. For instance, an
elevator can lock in a floor price for its own grain sale by purchasing put
options and then pass this floor price on to producers through a forward
contract. The cost of the put options, or the premium, would be included
in calculating the producer's floor price. Likewise, a merchant can lock
in a ceiling price on purchases by buying call options, which can then be
passed on to end users via a forward contract. Once again, the ceiling
price would reflect the exporter's cost of buying the calls. The mechanics
of these transactions will be demonstrated later.
A number of advantages to both merchants and their customers can be
realized by incorporating options into forward contracts. The biggest
advantage to producers and end users is that they could lock in a floor or
ceiling price and would be able to benefit from a favorable cash price
move; with traditional forward contracts they would not. Furthermore, the
new forward contract would permit individuals to take advantage of options
indirectly through the merchant without being directly involved in the
option market or understanding the mechanics themselves. Merchants will
benefit from this new concept as long as their customers make use of the
program. This is evident because the merchant's return is dependent on
throughput. Consequently, one of the most important advantages of a forward contract based on options is that it offers another merchandising
alternative and could stimulate additional grain handled.
Specific examples of forward contracts with floor and ceiling prices
are given below:
Forward Contracts with Floor Prices:
Forward purchase contracts have typically been made at fixed prices.
One of the most common transactions with this type of contract is
between an elevator and a producer. If the elevator is doing a good
job of marketing through the futures market and reflects this in its
forward contracts, the producer need not become directly involved in
the futures market. Part A of Example 5 illustrates how an elevator
calculates the traditional forward contract price and hedges in the
futures market.
- 18 -
__
EXAMPLE 5. DERIVATION OF FORWARD CONTRACTS FOR PURCHASE (I.E., TO

PRODUCERS) WITH PRICE FLOOR
Setting:
September 3, 1984
December Futures
3809
Basis (Terminal Market)
309
Trans. and Handling
509
December 380 Put
89
A. Derivation of conventional forward contract price: Hedge by
selling December futures
Calculation:
December futures
3809
Basis
+30
Trans. and handling -50
Producer Price
3609
B. Derivation of forward contract prices with price floor: Buy put
options
Calculation:
Strike Price
380O
Basis
30
-50
Trans. and handling
-8
Less put premium
Producer Price
3529
1. If December futures increase to 420% by November 1
a) Option will not be exercised but will be offset
b) Derivation of producer price:
December futures
4209
30
Basis
-50
Trans. and handling
-8
Less option premium
(Sept. 3)
0
Plus option value
(Nov. 1)
Producer Price
392%
2. If December futures decrease to 350' by November 1
a) Option can be exercise, or offset
b) Derivation of producer price:
3509
December futures
30
Basis
-50
handling
and
Trans.
Less option premium
(Sept. 3)
Plus option premium
(Nov. 1)
Producer Price
- 8
30
352?
- 19 -
This type of contract allows the producer to lock in a sale price of

$3.60. The disadvantage of this contract is that the producer cannot
benefit from a rise in prices. The use of options will alleviate
this problem.
A forward contract with a floor price can be offered if the merchant
incorporates put options into the scheme. Part B of Example 5 shows
how this floor price is derived and the consequences of a change in
the underlying futures price over time. It should be noted in the
following examples that, once again, the option positions are assumed
to be offset.
In this example, the merchant purchased at-the-money put options at a
premium of 8 cents. It is demonstrated that the floor price quoted
to the farmer is less than the flat forward contract price by the
amount of this premium. Thus, the put premium will affect the
attractiveness of the price floor contract.
If the underlying futures price increased over the life of the
contract, the merchant could either let the option expire or
liquidate his position. It is assumed the position is liquidated;
however, there is no intrinsic or extrinsic value left in the option
so the merchant does not receive a premium on the sale. The merchant
does realize the greater future price, which is passed on to the producer. Consequently, the producer received $3.92 with the price
floor contract rather than $3.60 under the conventional forward
contract.
If the futures price decreased, the merchant could have exercised or
offset the option. Once again, it is offset. The merchant does
receive a premium of 30 cents on the sale in this case, because the
option has gained intrinsic value. However, this is discounted by
the futures price decline. The end result is that the producer
realized the floor price.
Forward Contracts With Ceiling Prices:
Traditionally, domestic and export merchants have offered forward
sales contracts at fixed prices. The futures market is an important
component in determining the specific price. Part A of Example 6
demonstrates how the conventional forward price is derived and the
appropriate futures position taken. This type of contract is
appealing to buyers, such as importers, if they can establish prices
for deferred delivery.
from price reductions.
However, by doing so, they do not benefit
Options give merchants the opportunity to change the typical forward

contract. A merchant could offer a forward sale contract with a
ceiling price by purchasing call options. The mechanics are identical to the earlier example of a merchant with a short cash position. By purchasing calls, the merchant locks in a ceiling price and
can pass this on to his customers via a forward contract. The only
- 20 -
EXAMPLE 6. DERIVATION OF FORWARD CONTRACTS FOR SALE (E.G., TO

IMPORTERS) WITH PRICE CEILING
Setting:
September 3, 1984
December Futures
3809
Basis (Terminal Market)
30O
Trans. and Handling
50O
December 380 Put
8%
A. Derivation of conventional forward contract price: Hedge by
buying December futures
Calculation:
December futures
380O
Basis
+30
Trans. and handling +50
Offer Price
460%
B. Derivation of forward prices with price ceiling: Buy call options
Calculation:
Strike price
3809
Basis
30
Trans. and handling
+50
+ 8
Less put premium
Offer Price
468
1. If December futures increase to 420% by November 1
a) Option can be exercised or offset
b) Derivation of importer price:
December futures
420%
Basis
30
+50
Trans. and handling
+8
Plus option premium
(Sept. 3)
-40
Less option value
(Nov. 1)
Effective Purchase
468
Price
2. If December futures decrease to 350 by November 1
a) Option will not be exercised, but is offset
b) Derivation of importer price:
December futures
3509
Basis
30
Trans. and handling
Plus option premium
(Sept. 3)
Less option premium
(Nov. 1)
Effective Purchase
Price
+50
+ 8
0
438B
- 21 -
stipulation is that the cost of the calls is also passed on to the

customer, built in to the ceiling price. Importers, as well as other
end users, should find this contract more appealing because they can
still take advantage of a price decline, and it allows them to benefit from options without actually trading them.
The calculation of the forward ceiling price is demonstrated in
Part B of Example 6 along with the results of an increase and
decrease in the underlying futures price. The merchant bought atthe-money call options for a premium of 8 cents. The ceiling price
is then greater than the flat price by the amount of this premium.
If the underlying futures price increases, the merchant has two
alternatives: exercise or offset the option. For the sake of consistency it is again assumed that the calls are liquidated. The
increase in the underlying futures price results in a gain in the
option's intrinsic value, which is reflected in the 40-cent premium
earned on the call sale. This premium offsets the rise in the
futures price and is passed on to the importer. Consequently, the
price realized by the importer is equal to the ceiling price originally quoted to him.
If instead the futures price decreases, the merchant again has two
possibilities: to let the option expire or offset his position; the
latter was chosen here. The option's value drops to zero because of
the decline in the futures price so no premium was recovered on the
liquidation. However, because of the flexibility of options, the
merchant is able to pass the lower futures price on to the buyer.
Thus, the buyer must decide if locking in a ceiling price that is
greater than a flat forward price is worth the benefits received.
The conventional forward contract is more beneficial if prices do
rise, but is a riskier alternative.
Summary of Forward Contracts
A forward contract with a floor or ceiling price built-in is a new
marketing concept, the success of which depends on the conceptual
understanding by merchants, the premium values,'and effective prices
relative to farm programs prices. Country merchants can offer producers an
array of marketing alternatives ranging from fixed price to various floor
price contracts. Similarly, merchants could offer end users an array of
marketing alternatives ranging from fixed price to various ceiling price
contracts. The primary advantage of incorporating options into forward
contracts is that both the customer and the merchant can lock in a floor or
ceiling price, which not only allows the customer to benefit from options
without direct involvement in the options market but also could attract
business for the merchant. There are additional types of marketing
situations in which merchants may incorporate options, but the fundamental
positions will be similar. Specifically, traditional forward contracts
have characteristics similar to no-price-established (NPE) and basis
contracts although the latter have ulterior advantages. Thus, options may
also prove useful in augmenting other conventional marketing plans.
- 22
Quantity Risk
Another viable use of options is to hedge against quantity risk.
Many merchants make cash transactions after the futures exchanges have
closed and when the exact quantity is unknown. Consequently, there is risk
between the cash transaction price and the next day's price when the hedge
is placed. A solution to this problem would be to buy options. Another
type of quantity risk is characterized by a grain merchant's having tendered an offer to sell grain overseas but not knowing for several days
whether the offer will be accepted. During this time the price of the commodity could move up or down. If the exporter had hedged in the futures
market by purchasing futures and the offer was rejected after the price of
the commodity had fallen, the merchant would be subject to a loss in the
futures market. By purchasing call options instead, the exporter would
have ensured that if the offer was rejected, his loss would be limited to
the premium. Producers are also exposed to quantity risk in preharvest
hedging. Indeed, perhaps one of the hindrances detracting producer use of
futures for hedging is quantity or yield risk. As an alternative, producers could use options as a hedge, which in some cases is more approriate
when quantity risk exists.
The examples below illustrate the mechanics of the use of options
where quantity risk exists and are referred to as "Overnight Transactions."
Overnight Transactions
Example 7 demonstrates the mechanics of an overnight transaction.
The main feature of this example is a merchant's making an offer,
which remains valid for five days, to sell grain at $4.10 per bushel.
To hedge this tender, the merchant buys at-the-money call options at
a premium of 8 cents. The merchant does this because he wants to
establish a ceiling price so that if the offer is accepted and prices
rise, he can still profit. Likewise, he wants to limit his losses if
the offer is rejected and prices fall. Whether the offer is accepted
or rejected, however, the returns will depend on the movement of the
underlying futures price. Scenarios are then given for offers that
are accepted and rejected.
Part A of Example 7 illustrates that if the offer is accepted, the
merchant effectively has a short cash/long call position. Therefore,
the returns realized when the underlying futures price increases and
decreases can be calculated using the same mechanics as in previous
short cash/long call examples.
Part B shows the effects of a futures price increase and decrease
when the offer is rejected. It is apparent that the greatest return
will occur if the futures price increases. When the underlying
futures price increased, the merchant could either exercise or offset
the calls. It is assumed they are offset. The net return is simply
calculated by subtracting the premium initially paid from the premium
received upon liquidation. The intrinsic value of the premium appreciated over the five days because the futures price increased, thus
causing a positive net return.
- 23 -
EXAMPLE 7. OVERNIGHT SALE TRANSACTION

Setting:
September 3, 1984
Offer to sell @410% and offer remains valid for 5 days
380%
December Futures
30%
Basis
December 380 Call
8%
Buy Call
A. Offer Accepted
1. Calculate returns as in Example 3 (i.e., Short Cash/Long
Call)
B. Offer Rejected
1. December futures increased to 400O
a) Calculation of returns
- 8
Premium paid (9/3)
20
Premium received (9/7)
Net Result
12W
2. December futures decreased to 350O
a) Will not exercise option, but are offset
b) Calculation of returns
Premium paid (9/3)
- 8
0
- 8%
Net Result
When the futures price decreased, the merchant could let the options
expire or liquidate them; the latter was chosen here. No premium was
realized on the sale of the calls because the adverse price move
depleted the intrinsic and extrinsic values. Consequently, the net
return was negative, equalling the initial cost of the calls.
The same type of logic can be applied to a merchant who has made an
offer to buy grain, such as an elevator over a weekend. The only
difference will be that the merchant will hedge against quantity risk
- 24
by purchasing puts instead of calls. An illustration is given in

Example 8; an elevator manager makes an offer to buy over the
weekend, but the exact quantity is not known.
EXAMPLE 8. OVERNIGHT PURCHASE TRANSACTION

Setting:
August 31, 1984

Offer to buy @410% and offer remains valid for 3 days
380%
December Futures
30%
Basis
December 380 Put
8%
Buy Put
A. Offer Accepted
1. Calculate returns as in Example 1 (i.e., Long Cash/Long Put)
B. Offer Rejected
1. December futures increased to 400%
a) Options may be left to expire, but are offset
Premium paid (8/31)

Net Result
0
-
2. December futures decreased to 3709

a) Options could be exercised, but are offset
Premium paid (8/31)

Net Result
10
2(
Part A of Example 8 indicates that if the offer is accepted over the

weekend, the merchant is effectively in a long cash/long put
situation. The effects of an increase and decrease in the underlying
futures price on net returns can then be calculated using the same
procedures as previous long cash/long put examples.
- 25 -
The consequences of the offer being rejected with both an increase

and decrease in the futures price are demonstrated in Part B. When
the futures increased the merchant could either let the options
expire or offset them. Again, the latter was assumed chosen. No
premium resulted from the put sale because the value of the put
diminished with the rise in the futures price. The net result
equalled the original premium cost, -8 cents. When the underlying
futures price decreased, the merchant liquidated the options,
although he could have also exercised them. The premium received on
the sale of the puts had increased because the fall in the futures
price caused the intrinsic value of the puts to appreciate.
Therefore, the net return amounted to 2 cents even though the offer
had been rejected. Furthermore, options are more favorable as a
hedge in this case because the exact quantity of grain purchased is
unknown at the time of the offer. A futures hedge placed on a large
quantity of grain of which only a fraction was actually bought,
coupled with a rise in the futures price, could result in extensive
futures losses. However, the only loss incurred with an option hedge
is the premium cost.
Summary of Quantity Risk
Quantity risk imposes problems for traditional hedging for various
participants through the grain marketing option. Merchants are exposed to
quantity risk after having tendered an offer to buy or sell grain. A long
option position can be used to hedge against this risk by limiting the
possible loss to the premium cost. If the futures market was used, the
potential futures loss of an adverse price move is unlimited. In this
sense, options are more appropriate for reducing those futures for
relieving risk when quantity risk is present. A merchant that has tendered
an offer to sell grain but will not know for several days whether the offer
will be accepted can hedge this position by buying call options. If the
offer was accepted, the exporter would have been short cash/long calls. If
the offer was rejected, the results would again depend on the futures
price. The largest return in this scenario would be realized with an
increase in the futures price. An elevator may also post a price to buy
grain with the offer remaining valid for a specified number of days
(e.g., overnight or on a weekend). In addition, the estimated purchase may
only be partially fulfilled. Put options can be bought as a hedge against
this type of transaction. The maximum loss associated with a long put
position is the premium cost. If the offer was accepted, the elevator
would have a long cash/long put position. If the offer had been rejected
or partially fulfilled, the largest return would occur with a decrease in
the futures price. The premium would not have been recovered if the
futures price had increased. However, the loss would not be any greater
than the premium. Thus, a long option strategy appears to be more advantageous than a futures hedge when a merchant has tendered an offer for
either a purchase or a sale.
Producers likewise are exposed to quantity (yield) risk in preharvest hedging, and as such, their alternatives are similar to the elevator example above (i.e., long cash/long puts). In general, when quantity
- 26
risk exists for producers, it would be more appropriate to use options than
to use futures. The point is that it is generally cheaper to reduce risk
with the use of options than using futures when quantity risk exists. A
quantitative analysis of this is fairly extensive and is not presented
here.
Selected Decisions to be Made in the Use of Options
Users of agricultural options have a number of decisions that must be
made before or during the life of the option. The factors affecting these
decisions and the various end results must be understood in order to maximize the benefits from options. This section covers two separate choices
that have to.be made within the aforementioned time frame. There are many
more situations that may arise requiring additional decisions; however,
these are the most obvious and occur in all instances: (1)terminating an
option position and (2) use of in-the-money or out-of-the-money options.
Terminating Option Positions
Buyers of options have three basic choices that have to be made
during the life of the contract: exercise the option, offset the option,
or let the option expire. The direction that prices move over the life of
the contract will affect this decision. The alternatives for terminating a
long option position depend on price movements and are as follows:
Long Option
Contract
Prices Increase
Prices Decrease
Put
Let Expire
or Offset
Exercise or
Offset
Call
Exercise or
Offset
Let Expire
or Offset
The choice between letting the option expire and offsetting the option
is relatively easy. There is no chance of realizing any kind of monetary
gain directly from the option if it is left to expire. When it is sold
back to offset the position, there is the possibility the option will have
some remaining value reflected in the premium. This then could be gained
and used to partially cover the original premium cost. However, it should
be noted that there will likely be some commission costs associated with
offsetting the option. The choice between offsetting the option or letting
it expire depends on commission charges and premium values.
The choice between exercising and offsetting the option is not as
straightforward. The merchant must understand the differences between
exercising and offsetting options so he will know what consequence to
- 27 -
expect. Once again, offsetting will result in a possible premium gain and
no subsequent futures position. However, exercising will lead to a
specific position in the futures market at the designated strike price.
With this also comes the responsibilities of a futures position, such as
margins and commission costs. The futures position can be offset
immediately and a gain realized, or it can be held until-the cash position
is liquidated. The primary decision criteria in this case is whether or
not the merchant wants a position in the futures market. If he needs a
futures position (i.e., if he still has a cash position) the option should
be exercised; if not, the option should be liquidated.
Trends in the underlying futures price also play a role in determining whether options should be offset or exercized (for further information, see Klemme 1984). For example, in a market with a weak basis, and
a futures which has been increasing but may be reaching a peak, a trader
with a long cash/long put position would want to liquidate the option position and sell futures. The hedge has been transferred from an option to a
futures position. Likewise, there would be an incentive to liquidate a
short cash/long call position if futures have been falling but are showing
signs of turning.
In-the-Money Vs. Out-of-the-Money Options
An important consideration when purchasing options is whether to buy
in-the-money (ITM) or out-of-the-money (OTM) options. To review some terminology, an ITM put (call) is one whose strike price is higher (lower)
than the current futures market level, and an OTM put (call) is one whose
strike price is lower (higher) than the current futures market level. ITM
options have a.higher premium than OTM options, and the decision depends on
the level of risk exposure which is acceptable. One way to address this
problem is to look at the risk exposure for different strike prices under
long and short cash situations and compare possible net returns when the
futures price increases and decreases. The examples demonstrate that ITM
options provide greater protection from adverse price changes, but less
windfall gains from favorable price moves. On the other hand, OTM options
provide less protection from adverse price moves but generate greater
profits from favorable price moves.
Long Cash/Long Puts
The decision for a trader with a long cash/long put position is
whether to buy ITM puts to insure a higher selling price but pay a
larger premium, or to buy OTM puts which lock in a lower selling
price but at a smaller premium. A table can be constructed to
illustrate the risk exposure, or potential loss, at various strike
prices.
- 28 -
EXAMPLE 9.1.
Setting:
RISK EXPOSURE FOR DIFFERENT STRIKE PRICES WHEN LONG CASH/LONG PUTS
September 3, 1984
Dec. Futures
380%
Long Cash Based on Dec. Futures @ 380O
Buy Puts
Strike
Price
Out-of-Money
Out-of-Money
At-the-Money
In-the-Money
In-the-Money
Premium*
Net Minimum
Sales Price
for Futures
(0)
-(M)
()
350
370
380
390
410
.7
4.4
8.5
14.3
30.1
349.3
365.6
371.5
375.7
379.9
December
Futures on
Purchase
Maximum
Loss
Potential
( )
(%/Bushel)
380
380
380
380
380
30.7
14.4
8.5
4.3
0.1
*Derived using values for December futures and results from the Black/Scholes
Model.
**Derived as the difference between the Dec. futures at which long cash was taken
(380) and minimum sales price.
It is apparent that buying ITM puts results in a smaller risk exposure than purchasing OTM puts. Further, the deeper ITM the put is,
the smaller the risk exposure or potential loss. The calculations
used to arrive at the risk exposure, or the maximum loss potential,
are relatively easy to understand. Subtracting the premium from the
strike price results in the net minimum sales price for futures, or
the effective floor price that is locked in. The risk exposure is
then found by subtracting the floor price from the underlying
(December) futures price. The buyer should make sure that the option
strike price selected does not set a floor so low that too much of
his original margin (profit) is being risked. For example, an elevator operator would likely not use an option in which the potential
loss exceeds his margin.
Example 9.2 demonstrates the calculation of net returns for ITM and
OTM puts under conditions of rising and falling futures prices.
Part A shows the effects on net returns of an increase in the futures
price from $3.80 to $4.00 at various strike prices. The options are
assumed to be offset rather than left to expire; therefore, a premium
is included in calculating the net returns. The greatest return
under this scenario occurred with an OTM put (16.2 cents). This is
due to the favorable cash price move coupled with the relatively low
- 29 -
EXAMPLE 9.2.
Setting:
PURCHASE OF IN-THE-MONEY VERSUS OUT-OF-THE-MONEY PUTS
September 3, 1984
Buy cash wheat based on Dec. futures of 380?
Buy Puts
Nov. 1, Puts Liquidated, Cash Sold and No Change in Basis

A. Dec. Futures increased to 400? on Nov. 1
1. Options will not be exercised but are offset
2. Calculation of returns using different strike prices
Strike Price
Sale
Option
Sale Price
Purchase
Net
Price
Cost
of Option
Price
Returns
(-- .-----. - ---------------------)
OTM 370P:
ATM 380P:
400
400
- 4
- 8
+ .2
+1.4
-380
-380
=
=
ITM 390%:
400
-14
+2.7
-380
16.2
13.4
8.7
*Lower valued strike price gives greatest return.

B. Dec. Futures decreased to 360? on Nov. 1
1. Options could be exercised, but are offset
Strike Price
OTM 370P:
ATM 380P:
ITM 390P:
Net
Returns
Purchase
Option
Sale Price
Sale
Price
Cost
of Option
Price
(----------~------------)
360
360
360
- 4
- 8
-14
+11.4
+20.6
+30.0
-380
-380
-380
=
=
=
-12.6
- 7.4
- 4.0
*Lower valued strike price gives greatest loss.

premium cost. However, the net return from the ITM put was still
positive and obviously beneficial. Part B illustrates the results of
a decrease in the underlying futures price from $3.80 to $3.60. In
this case, the OTM puts lead to the greatest net loss. The reason is
because the premium received from the sale did not increase proportionally with that of the ITM put.
The fundamental conclusion that can be drawn from this example is
that purchasing OTM puts can result in both the largest potential
return and greatest potential loss, depending on the change in
- 30 -
futures prices. Thus, a risk averse buyer wanting to reduce the

variability in net returns should buy ITM puts. The potential windfall gains will not be as great, but the possible loss will be much
less relative to OTM puts.
Short Cash/Long Calls
The only difference in a short cash/long call position is that the
merchant wants to "insure" a specific purchase price. First, the
risk exposure or potential loss for various strike prices can be
determined. Example 10.1 indicates that the lowest amount of risk
occurs when ITM calls are bought, which is identical to the put scenario. Likewise, the deeper ITM the call is, the lower the risk
exposure. Conversely, the deeper OTM the call is, the greater the
potential loss. In this situation the maximum purchase price, or
guaranteed ceiling price, is found by adding the call premium to the
strike price. Subtracting the December futures price from this
ceiling price results in the risk exposure or potential loss.
Example 10.1 demonstrates that lower ceiling prices offset the higher
premiums of ITM calls, whereas buying OTM calls results in a price
ceiling that exposes the buyer to a relatively greater risk. In each
case the net return was negative, but the smallest loss resulted from
the deeper ITM options.
EXAMPLE 10.1. RISK EXPOSURE FOR DIFFERENT STRIKE PRICES WHEN SHORT
CASH/LONG CALLS
Setting:
September 3, 1984
Dec. Futures
Short Cash Based on Dec. Futures
Buy Calls
In-the-Money
In-the-Money
Strike
Price
(9)
350
370
At-the-Money
Out-of-Money
Out-of-Money
380
390
410
Premium*
(U/Bushel)
30.0
14.0
8.4
4.5
0.9
380%
@3809
December
Net Maximum
Futures on
Purchase Price
Sales
for Futures
(- - - - - - - - - - - -)
380.0
380
380
384.0
388.4
394.5
410.9
380
380
380
Maximum
Potential
Loss
(f/Bushel)
0
4.0
8.4
14.5
30.9
*Derived using current values for Dec. futures and Black/Scholes Model.
**Derived as the difference between the Dec. futures at which sort cash was
taken (380) and maximum purchase price.
- 31 -
The net returns for ITM and OTM calls when futures prices increase
associated with OTM calls is supported by this example. Part A
illustrates that a 20-cent rise in the futures price resulted in the
largest net return, 4 cents, when ITM calls were purchased. The
explanation for this is that the premium from the ITM call sale
increased more in proportion to the OTM call sale.- The greatest loss
occurs with OTM calls.
The returns in Part B are exactly the opposite, where the largest
gains, 15.5 cents, were realized with OTM calls. The futures price
had declined from $3.80 to $3.60 and the options were eventually
liquidated, although no premium was earned from the sale of the OTM
calls because the futures price move discounted the remaining option
value. The reason for this large return was the relatively small
option cost, 4.5 cents, in comparison to 14 cents for ITM calls. At
the same time, the premium received from the ITM call sale was not
large enough to bring the net cost closer to that of the OTM call.
Example 10.2 demonstrates a conclusion similar to that of the previous example: buying OTM calls results in both the largest possible
return and the greatest potential loss, depending on the move of the
underlying futures price.
Summary of Options
The thrust of this section has been to demonstrate the impacts of
purchasing options with different strike prices as a hedge. The cheaper
out-of-the-money options are obviously preferrable so long as prices do not
move adversely. In-the-money option premiums are greater but offer greater
protection in the case of an adverse price move. In general, use of inthe-money options results in the least loss potential and the least potential for windfall gain, depending on subsequent movement in futures prices.
Likewise, use of out-of-the-money options results in the greatest potential
for windfall gains and the greatest potential loss, again depending on subsequent movement in futures prices. Table 2 summarizes these results.
TABLE 2. OUTCOME OF A CHANGE IN FUTURES PRICES ON LONG ITM AND OTM

POSITIONS
Long Cash/Long Put
Change
Short Cash/Long Call

Strike Prices
in Futures
ITM
OTM
Increase
Least Return
Greatest Return
Least Loss
Greatest Loss
Decrease
Least Loss
Greatest Loss
Least Return
Greatest Return
ITM
OTM
- 32 -
EXAMPLE 10.2
Setting:
PURCHASE OF IN-THE-MONEY VERSUS OUT-OF-MONEY CALLS
September 3, 1984
Sell cash wheat based on December futures @380
Buy Calls
Nov. 1, Calls Liquidated, Cash Bought and
No Change in Basis
A. Dec. Futures increased to 400? on Nov. 1
1. Options can be exercised, or offset
Strike Price
ITM 370P:
Option
Sale
Cost
Price
(.--.-----------+380
-14.0
Components of Return
Sale Price Purchase
Price
of Option
--.---+30.0
Net
Returns
)...)
-400
- 7.1
-11.8
ATM 380P:
+380
- 8.4
+21.3
-400
OTM 3909:
+380
- 4.5
+12.7
-400
4.0
*Lower valued strike price gives least loss.

B. Dec. Futures decreased to 360 on Nov. 1
1. Options cannot be exercised, but will be offset
Sale
Strike Price
Option
Cost
Price
(----------
Sale Price
Net
Purchase
Returns
Price
of Option
-- --------------------------
ITM 370P:
+380
-14.0
+1.4
-360
7.4
ATM 380%:
OTM 390:
+380
+380
- 8.4
- 4.5
+0
+0
-360
-360
=
=
11.6
15.5
*Lower valued strike price gives least return.

The use of ITM versus OTM options as a hedge depends on the
merchant's or producer's capacity of absorbing risk. For example, a
country elevator or merchant should use deeper ITM options as a hedge so
that their potential loss is less than their margins. Producers, on the
other hand, have different capabilities for absorbing risk. Consequently,
for some OTM options, being cheaper and more risky would be appropriate,
and for others deeper ITM options should be used.
- 33 -
Pricing of Commodity Options

Concept
A basic understanding of option premiums or prices-is important in
making effective decisions on the use of options for hedging. The purpose
of this section is to briefly describe factors influencing option premiums
although a more thorough description is available elsewhere (see Selected
Bibliography, particularly Mayer, Barclay, and Chicago Broad of Trade).
An option premium has two components, the intrinsic and extrinsic
values, which can be expressed as
Premium = Intrinsic Value + Extrinsic Value
Intrinsic value represents the amount that the option is currently in-themoney. For example, if the futures price for December wheat was 3809 at
Minneapolis and the call option's strike price was 350, the intrinsic value
of the option would be 30.
However, an option's premium typically exceeds
the amount of intrinsic value, which is represented by the extrinsic value.
Basically, the extrinsic value represents the possibility that, over time,
the option will trend into-the-money. Many factors affect the extrinsic
value of an option, including
1.
2.
3.
4.
the length of time until option expiration

volatility of the underlying futures market
short-term interest rate
the relationship between market and strike price
Each of these are discussed below.

Length of Time
Everything else assumed equal, the more time an option has until
expiration, the higher its premium. The underlying logic is that over a
longer period of time, there is a greater chance for an unexpected event to
develop, which would adversely affect an unhedged cash position. Thus,
buyers are willing to pay more for the longer term of protection. Likewise,
sellers wish to receive a higher premium to compensate for the longer period
of protection offered. Table 3 shows that option premiums increase as their
duration increases when the following conditions are given:
Futures price
Strike price
Market volatility
Interest rate
= 380O
= 380O
= 10 percent
= 10 percent
1The option pricing model developed by Black and Scholes (1976) is

used to compute option premiums, this model will be discussed in a later
section.
- 34 -
TABLE 3.
Futures
Price
OPTION PREMIUMS FOR VARIABLE MATURITIES

Strike
Price
Days To
Maturity
Days
Market
Volatility
%
Interest
Rate
Call
Premium
Put
Premium
P/bu.
P/bu.
P/bu.
U/bu.
380
380
30
10
10
4.31
4.31
380
380
60
10
10
6.05
6.05
380
380
90
10
10
7.34
7.34
380
380
120
10
10
8.41
8.41
380
380
159
10
10
9.33
9.33
The premium is 4.31% (option premiums shall fluctuate in minimum fractions

depending on the underlying commodity) for an option (either put or call)
with 30 days left until expiration. But the premium for a 60-day option is
6.05%, which is an increase of more than 1.7% from the 30-day option.
Premiums for both puts and calls are the same when the strike prices are
at-the-money. The intrinsic values for both are zero when the options are
at-the-money, while the extrinsic values are the same because both options
have the same market volatility, interest rate, and days to maturity.
Although options of greater durations have higher absolute costs,
their average cost per day are substantially less. For example, the per-day
cost of a 30-day option in Table 3 is 0.14/bushel, but the per-day cost of
a 90-day option decreases to 0.08/bushel. One may also expect the premium
of an option to depreciate uniformly over its duration; however, this is not
the case at all. As shown in Figure 1, the curved line depicts the way the
premium of an option actually depreciates with the passage of time.
In the early days of trading an option, its premium depreciates
slowly. As the option approaches expiration, the rate of depreciation in
the extrinsic value accelerates. A hedger using options as a hedge should
liquidate his position as soon as possible in order to regain the premium
before a significant portion is depreciated. A speculator who anticipates a
change in the premium should also make some judgement as to the time frame
in which the change is expected to take place and should intend to liquidate
the option before any significant depreciation takes place.
Market Volatility
Market volatility in this context refers to the annualized standard
deviation of commodity returns. In other words, it is a measure of the
- 35 -
Premium
rate
reciation
Time (Months) Remaining

Figure 1. Rate of Depreciation of Option Premiums Over Time
fluctuation of percentage return on a particular commodity over the next
year. (For a more detailed discussion, refer to Labuszewski 1984.)
Everything else remaining equal, the premium will be higher if the
volatility of the underlying futures market is greater. In times of high
volatility:
1. there is a greater need for price protection, and buyers of
options are willing to pay more
2. speculators will also pay more because of the higher potential of
profit resulting from a volatile market.
On the other hand, the seller will expect to receive more:
1. to justify for the higher level of protection offered
2. to protect from any unfavorable price movements.
As shown in Table 4, an increase of volatility from 5 percent to 10 percent
results in an increase in premiums (both call and put) from 3.67 to 7.34t.
The holders of options, whether puts or calls, have to pay higher premiums
due to the higher volatilities in the underlying futures market.
Seasonal fluctuations in the fundamentals of the underlying futures
commodity are also reflected in the option premiums (Cargill 1985). For
example, there are greater uncertainties about fundamentals at different
times of the crop year (e.g., preharvest) which are then reflected by the
- 36 -
TABLE 4. OPTION PREMIUMS FOR DIFFERENT LEVELS OF MARKET VOLATILITY

Call
Put
Futures
Strike
Days To
Market
Interest
Price
P/bu.
Price
N/bu.
Maturity
Days
Volatility
%
Rate
%
Premium
/bu.
Premium
%/bu.
380
380
90
10
3.67
3.67
380
380
90
10
10
7.34
7.34
380
380
90
15
10
11.01
11.01
380
380
90
20
10
14.68
14.68
380
380
90
25
10
18.35
18.35
volatilities of futures prices. Since option premium values are directly

related to market volatility, any uncertainty about the fundamentals will be
reflected in the premiums as well.
Interest Rates
The levels of interest rates and option premiums tend to be inversely
related (Table 5). At higher levels of interest, the return to interestbearing investments increases, which means an increase in the opportunity
cost of holding an option position. The competition between options and
alternative investments will tend to decrease option premiums. The exact
opposite will occur when interest rates are low.
Relationships Between Market and Strike Price
There are several aspects involved in the relationship between market
and strike prices. For call options, the premium decreases as the strike
price increases relative to the futures price. The exact opposite occurs
for put options. To illustrate, call and put premiums are calculated for an
option with the underlying futures price at 380 and with 7 strike prices,
as shown in Table 6.
An option's extrinsic value is greatest when it is trading at-themoney, whether puts or calls. As the strike price changes from 390 to
370, a call option is going from out-of-the-money to in-the-money, and the
absolute level of the premium rises. As shown in Table 7, the intrinsic
value of a call option with the futures price at 380 and strikes at 370w is
10P/bushel. The extrinsic value can be found by subtracting the intrinsic
- 37 -
TABLE 5. OPTION PREMIUMS FOR VARIABLE INTEREST RATE

Futures
Price
Strike
Price
%/bu.
%/bu.
380
380
Days to
Maturity
Market
Volatility
Days
90
Interest
Rate
Premium
Call
Premium
P/bu.
/bu.
-Call
10
7.43
7.43
10
10
7.34
7.34
10
15
7.25
7.25
10
20
7.16
7.16
10
25
7.08
7.08
90
380
380
90
380
380
90
380
380
90
380
90
380
TABLE 6. OPTION PREMIUMS FOR VARIABLE STRIKE PRICES

Futures
Price
P/bu.
Strike
Price
/bu.
9/bu.
Delta
(call)
%
Put
Premium
9/bu.
Delta
(put)
%
Call
Premium
380
350
30.00
1.00
0.36
0.05
380
360
20.77
0.87
1.26
0.13
380
370
13.15
0.71
3.39
0.29
380
380
7.34
0.51
7.34
0.49
380
390
3.56
0.31
13.31
0.69
380
400
1.48
0.16
20.99
0.84
380
410
0.52
0.07
30.00
1.00
value from the premium, which for a 3700 strike is 3.150/bushel. To compare
this with the premium when the option is at-the-money, which reflects only
the extrinsic value of 7.349, one can see that the extrinsic value is higher
when it is at-the-money. The same logic can be applied to a put option.
- 38 -
TABLE 7. INTRINSIC AND EXTRINSIC VALUE FOR DIFFERENT STRIKE PRICES OF CALL
OPTION
Futures
Price
Strike
Price
?/bu.
U/bu.
380
360
90
10
10
20.77
20
0.77
380
370
90
10
10
13.15
10
3.15
380
380
90
10
10
7.34
7.34
390
90
10
10
3.56
10
400
90
10
10
1.48
20
380
380
Days to
Maturity
Market
Interest
Volatility Rate
Days
Call
Premium
U/bu.
Intrinsic Extrinsic
Value
Value
U/bu.
/bu.
Black/Scholes Pricing Model

There are a number of different formulae to calculate the value of an
option premium. The calculated premiums do not represent what actual premiums are; it is only a reflection of their "fair market value" (i.e., what
premiums are likely to be after most of the significant factors in the
pricing of options are considered). The most popular formula, developed by
Professors Black and Scholes, is used for the purpose of illustration and
calculation. The Black/Scholes model may be stated as
-rt
C = e
[UN(dl) - EN(d 2 )]
Where dl = [1n(U/E) + (sd2t)/2]/sd
d2 = E1n(U/E) - (sd2t)/2]/sd
C = call premium
U = underlying futures price
E = exercise price
r = short-term interest rate
t = term to option expiration (in years)
sd = market volatility (standard deviation of market returns on
annualized basis)
- 39 -
N = refers to normal cumulative probability distribution 2

e = 2.7183 (base of the natural logarithm)
In = the natural log of the term
Puts are priced similarly as
P = -e rtUN(-d 1 ) - EN(-d 2 )]
Black/Scholes model assumes that

1. The short-term interest rate is known and is constant through
time.
2. The futures price follows a random walk in continuous time with a
variance rate proportional to the square of the futures price.
Thus, the distribution of possible futures prices at the end of
any finite interval is log-normal. The variance rate of the
returns on the futures contract is constant.
3. The option is not "European"; that is, it can be exercised any
time before expiration.
4. Transaction costs are negligable.
5. There is no penalty to short selling (Black/Scholes 1973).
The Black/Scholes model is used to compute option premiums for both
puts and calls and their respective delta factors (which will be discussed
in the next section) for a 90-day December 1984 spring wheat option at
Minneapolis, with market volatility at 10 percent and interest rate of 10
percent. Table 8 presents the results.
The call premium decreases as the strike price increases (as the call
goes from deep in-the-money to deep out-of-the-money), while the put premium
increases as the strike price increases (as the put goes from deep out-ofthe-money to deep in-the-money). When an option is deep in-the-money, the
premium equals the intrinsic value, and the extrinsic value is zero. This
happens because a deep in-the-money option has so much protection against
adverse price changes that the impacts of extrinsic variables are insignificant.
The option premiums for both puts and calls calculated by the
Value of normal cumulative probability distribution can be identified by using a table of normal probability distribution. For example, if
the value of d1 in N(d ) is positive, adding .5 to the table value will give
the value of normal cumulative probability distribution. If d1 is negative,
subtract the table value from .5.
- 40 -
TABLE 8.
OPTION PREMIUMS AND DELTA COMPUTED FROM BLACK/SCHOLES MODEL
Futures
Price
Strike
Price
Call
Premium
Delta
(call)
Put
Premium
Delta
(put)
7/bu.
/bu.
/bu.
U/bu.
370
340
30.00
1.00
0.31
0.04
370
350
20.66
0.87
1.15
0.13
370
360
12.98
0.72
3.22
0.28
370
370
7.15
0.51
7.15
0.49
370
380
3.39
0.30
13.15
0.70
.370
390
1.37
0.15
20.88
0.85
370
400
0.46
0.06
30.00
1.00
380
350
30.00
1.00
0.36
0.05
380
360
20.77
0.87
1.26
0.13
380
370
13.15
0.71
3.39
0.29
380
380
7.34
0.51
7.34
0.49
380
390
3.56
0.31
13.31
0.69
380
400
1.48
0.16
20.99
0.84
380
410
0.52
0.07
30.00
1.00
390
360
30.00
1.00
0.41
0.05
390
370
20.88
0.86
1.37
0.14
390
380
13.31
0.71
3.56
0.29
390
390
7.54
0.51
7.54
0.49
390
400
3.73
0.31
13.48
0.69
390
410
1.59
0.16
21.10
0.84
390
420
0.58
0.07
30.00
1.00
"
- 41 -
Black/Scholes model have relationships and characteristics as expected and

described in previous sections. However, these results represent only an
estimation of option premiums, fair market value, and therefore, must only
be used as a guideline in decision making.
Delta Factor
The delta factor is also an important and useful variable which can
be derived from the Black/Scholes model. It is represented as the term
N(D1) for call and N(-dl) for puts in the formula. When the underlying
futures price changes, option premiums will also fluctuate to reflect this
movement. The rate at which the price of an option changes in relation to
the price change of the underlying futures price is referred to as the delta
factor. To be more specific, the delta factor represents the percentage
change of an option's premium given a 1 percent change in the underlying
futures price. For example, if the delta factor of an option is .50, this
implies that the premium will change by a factor of 50 percent of the change
of underlying futures price.
As shown in Table 8, when an option is deep out-of-the-money, the
delta factor would be close to zero because the premium will not be very
responsive to minor changes in the underlying futures price. On the other
hand, when an option is deep in-the-money, the delta factor will be high and
close to one. For any movements in the underlying futures price, the premium will follow closely. When attempting to hedge a futures position with
options, professional traders frequently refer to the delta factors. For
example, a delta factor of .50 implies that two option positions should be
established against every cash or futures position. For a more detailed
discussion see Mayer.
Recent Premiums
Futures and option prices for Minneapolis Grain Exchange's March 1985
hard red spring wheat and Chicago Board of Trade's March 1985 soybeans are
recorded in Table 9. The Wednesday closing prices from November 1984 to
February 1985 are listed. During that period of time, interest rates
remained relatively constant and the volatility of the Minneapolis wheat
futures market was relatively low at 7.38 percent. It is readily observable
that when the futures price of Minneapolis wheat decreased, the call premiums decreased while put premiums increased. The decrease in call premiums
is also partially explained by the reduced time left to maturity.
85)
TABLE 9. FUTURES AND OPTION PRICES:
FEBRUARY 1985.
MINNEAPOLIS WHEAT AND CHICAGO SOYBEANS, NOVEMBER 1984 TO
Options (March 85)
Futures (March 1985)
Date
Minneapolis
Wheat
Chicago
Soybeans
11/07
11/14
11/21
11/28
12/05
32500
12/19
12/26
01/02
01/09
01/16
01/23
01/30
02/06
02/13
02/20
3.9275
3.8700
3.8425
3.7900
3.7400
3.6600
3.7200
3.7200
3.7300
3.6675
3.6850
3.6700
3.6950
3.6900
3.6650
3.6525
6.6675
6.5375
6.4400
6.3150
6.2700
6.1025
6.1675
6.1550
5.9525
6.0050
6.0625
6.1200
6.1650
6.1000
5.9175
5.9250
Minneapolis 380 Wheat

Chicago 625 Soybeans
Wheat Put Options
Put
Call
Call
No trade
No trade
No trade
.63750
.57500
.32500
.32500
.37500
.37500
.22500
.30000
.30000
.22500
.22500
.20000
.12500
2.5000
4.2500
5.2500
6.5000
1.0000
13.5000
11.5000
11.0000
11.0000
14.0000
12.0000
11.0000
13.0000
11.0000
13.0000
15.0000
61.0000
51.0000
44.0000
32.0000
33.0000
18.0000
21.5000
19.5000
10.0000
11.2500
12.2500
14.2500
16.5000
13.2500
6.1250
4.8125
20.0000
24.0000
25.5000
27.0000
24.0000
31.0000
29.0000
27.0000
39.0000
36.0000
30.0000
27.0000
25.5000
27.5000
38.0000
37.5000
- 43 -
Summary
Options on agricultural commodity futures began trading in October
an experimental basis. Introduction of options can be viewed as an
on
1984
innovation or as a new technology for marketing. There are a multitude of
ways in which options can be used by merchants or producers--some as a
complement and others as a substitute for traditional hedging. Their primary advantage for hedging is their ability to lock in a floor or ceiling
price, allowing the merchant/producer to take advantage of favorable price
moves in the underlying commodity. The examples in this publication
demonstrate uses of options for long and short cash positions and forward
contracting, and the implications of using in-the-money versus out-of-themoney options. In addition, the components of option premiums were
discussed and followed by the development of a pricing model.
- 44
Selected Bibliography
This listing includes works referenced in the text as well as selected
works the reader may find useful for additional insight into commodity
options.
"Agricultural Commodity Options."
(no. 47-5): 15-16.
1983.
Doane's Agricultural Options 46
Barclay, William. 1983. How Much Will Option Premium be Theory and
Reality. Chicago: Economic Research, MidAmerica Commodity Exchange.
Belongia, Michael T. 1983. "Commodity Options: A New Risk Management Tool
for Agricultural Markets." Federal Reserve Bank of St. Louis.
Black, Fisher, and Myron Scholes. 1973. "The Pricing of Options and
Corporate Liabilities." Journal of Political Economy 81 (May/June):
University of Chicago Press.
Bowe, James. 1982. "Cutting Risk with Commodity Options."
(December): 64-65.
Cargill Inventory Service.
1985.
Insight.
Chicago.
Commodities
March 11.
Chicago Board of Trade. 1984. Options on Soybean Futures--Contracts

Fundamentals, Pricing, and Application-s. Chicago. Revised February 9.
Chicago Board of Trade. 1984.
Pricing, and Applications.
Options on Soybean Futures--Fundamentals,

Chicago. June.
"Cotton Options - A New Risk Management Tool for the Producer, Merchant,
and Mill." 1983. CFTC AgReport 4 (no. 4): 8-10.
Dalton, James F., and Bailey, Fred. 1984. A Guide To: Options Strategies
for the Farm Business. Chicago: J. F. Dalton Associates.
Figlewski, Stephen, and Fitzgerald, M. Desmond. 1981. "The Price Behavior
of London Commodity Options." Review of Research and Futures Markets
(no. 1, May): 90-104.
Hauser, Robert J., and Andersen, Dane K. 1984. "Modifying Traditional
Option Pricing Formulae for Options on Soybean Futures." Paper presented at the 1984 AAEA Meeting, August 5-8 at Cornell University.
Horner, David L., and Moriority, Eugene. 1983. "The CFTC Options Pilot
Program: A Progress Report." Education Quarterly 3 (no. 3): 9-14.
Kenyon, David E. 1984. Farmer's Guide to Trading Agricultural Commodity
Options. Agricultural Information Bulletin No. 463. Washington, D.C.:
USDA, Economic Research Service.
- 45 -
Kenyon, David E. 1984. The Use of Futures Versus Put Options in Pricing
Corn Production in Virginia. Blacksburg: Virginia Polytechnic
Institute and State University, Department of Agricultural Economics,
August.
Klemme, Diana. 1984. "Ag Options, Missing Link in the Marketing Alternatives Chain?" Grain Storage and Handling (February): 26-33.
Klemme, Diana. 1984. "Ag Options 2, A Merchandising Tool for the Country
Elevator." Grain Storage and Handling (August): 39-45.
Labuszewski, John. '1983. "How to Produce Your Own Tables of Option
Premiums, Deltas." Futures 12 (no. 10, October): 106-8.
Labuszewski, John. 1983. "Volatility Key to Finding Fair Option's
Premium." Futures 12 (no. 9, September): 84.
Labuszewski, John W.., and Meisner, James F. 1984. "Diagonal Options Offer
Risk-Reward Alternatives." Futures 13 (no. 6, June): 87-92.
Mayer, Terry S. 1983. Commodity Options: A User's Guide to Speculation
and Hedging. New York: New York Institute of Finance.
Meisner, James F., and Labuszewski, John W. 1983. "How 'Worthless' Options
Can Wind Up 'In-the-Money'." Futures 12 (no. 2, November): 76-77.
"Minneapolis Grain Exchange/Hard Red Spring Wheat Options Contract."
Proposed Option Contract Terms. April.
Moriarty, Gene; Phillips, Susan; and Tosini, Paula. 1983. CFTC, "A
Comparison of Options and Futures in the Management of Portfolio Risk."
The Commodity Futures Trading Commission. Education Quarterly 2,
(no. 1): 5-11.
"Options One Year Later:
12 (no. 10, October):
Index Contracts Big Winners."

99-101.
"Option Strategies - Straddles and Strangles."

Cargill Investor Services, Inc. June 11.
Rowlan, Tedi H. 1984.
"Ag Options Update."
1984.
1983.
Insight.
Futures
Chicago:
Com-Line 4 (no. 4): 6-7.
Sorkin, Jay. 1983. "In Options Two Longs Can Make a Write."
12 (no. 10, October): 110-12.
Futures

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Agricultural Economics Rpt. No.

Commercial and Producer Applications Using

Department of Agricultural Economics

This report provides a brief descrip-

tion on use of options by merchants and producers.

The advantage of using

options is their ability to lock in a floor or ceiling price for the

To do so, the hedger pays a premium.

sense options are analogous to price insurance whereby a premium is paid to

In many cases options are more appropriate hedging vehicles

when quantity or yield risk is present.

Mechanics and examples of each of

these applications are presented in this publication.

Commodity Options: Introduction ...................

MERCHANT CASH POSITIONS AND USE OF FUTURES AND OPTIONS . . . .

OUTCOME OF A CHANGE IN FUTURES PRICES ON LONG ITM AND OTM

OPTION PREMIUMS FOR VARIABLE MATURITIES

OPTION PREMIUMS FOR DIFFERENT LEVELS OF MARKET VOLATILITY

OPTION PREMIUMS FOR VARIABLE INTEREST RATE ..........

OPTION PREMIUMS FOR VARIABLE STRIKE PRICE

INTRINSIC AND EXTRINSIC VALVE FOR DIFFERENT STRIKE PRICES OF

OPTION PREMIUMS AND DELTA COMPUTED FROM BLACK/SCHOLES MODEL

FUTURES AND OPTION PRICES: MINNEAPOLIS WHEAT AND CHICAGO

LONG CASH/LONG PUTS

LONG CASH/SHORT CALLS

SHORT CASH/LONG CALLS

SHORT CASH/SHORT PUTS

DERIVATION OF FORWARD CONTRACTS (I.E., PRODUCERS WITH PRICE

DERIVATION OF FORWARD CONTRACTS FOR SALE (E.G., TO IMPORTERS)

OVERNIGHT SALE TRANSACTION . .................

OVERNIGHT PURCHASE TRANSACTION . ..........

COMMERCIAL AND PRODUCER APPLICATIONS USING

- Option buyers pay a negotiated cash premium to the

- The price at which a call (put) option holder may buy

In-the-Money- A call (put) is in-the-money if its strike price is

- A component of the option premium which is measured in

- Another component of an option premium, measured by the

Time Value = Premium - Intrinsic Value

- The date that is the last day that a holder of a put or

Merchandisers and, to a lesser extent, producers are familiar with

A short call position would be taken if he had essentially bearish or

MERCHANT CASH POSITIONS AND USE OF FUTURES AND OPTIONS

Traditional Futures Positions

Alternative Option Positions

- locks in floor price

long futures position

-8also requiring margin money. Alternatively, this cash position could be

-9Long Cash/Long Puts:

EXAMPLE 1. LONG CASH/LONG PUTS

A. Sell cash on November 1 at which time December futures increased

Less premium paid

Plus premium earned

Effective Sale Price

B. Sell cash on November 1 at which time December futures decreased

Less premium paid

Plus premium earned

Effective Sale Price

Long Cash/Short Calls:

LONG CASH/SHORT CALL

A. Sell cash on November 1 at which time December futures increased

Option premium earned

Effective Sales Price

*Loss in option is offset by gain in cash value.

Option premium earned