Options

[Marusko]

Anyone here use options? I am interested to learn about them to see if I can open up some income potential. I can think of a couple times in the past few years where I wanted to forward-contract some in the spring/summer but didn't want to sell too much before harvest.

How does it work exactly? Who do you do it through? How does it work for taxes?

[burnt]

At the risk of offending the knowledgeable and turning off the uninitiated, I'll give this one a try :-)

When you buy an "option", you are merely buying the right or, the "option" to buy or sell a commodity at a predetermined price.

There is quite a bit of language to learn in options:

Strike price - the price per bushel at which you choose to fix your value/bushel.

Call options - you buy them if you want to capture potential upward market moves, in the event that you sold your crop. A call option gives you the right to buy a commodity at your chosen "strike price".

Put options - you buy them when you want to protect against downside price risk for crop in the field or in storage, but not sold. A put option gives your the right to sell a commodity at your chosen 'strike price".

"In", "out of", or "at" the money - how close the chosen strike price is to the actual board price in that trading month.

Premium - the cost per bushel of fixing your chosen price per bushel. The premium is variable depending on the strike price you choose and also affected by how far in the future the month of the contract you are buying.

A nearby month will have a lower premium because there is less time/risk for a big market move. A far off month will naturally command a higher premium reflecting the higher time/risk of a major move.

Options are a so-so way of managing risk either way. If you wanted to lock in a decent price before your crop was "made" or in the bin, you would buy put options to protect against downside movement, while leaving the upside wide open.

For example, say it's July and Chicago soybean board price is $12.00 for the November contract/delivery. You like that price but don't want to forward contract something you do not yet have, so, for a premium of so many cents or dollars per bushel, you buy a piece of paper (a put option) that says you have the right to sell whatever amount you contract for $12.00/bu. The $12.00 figure is called the "strike price".

You will pay a fairly hefty premium, but whatever price you pay for it is the extent of your risk.

If the market moves above your chosen strike price, your premium will lose value roughly equivalent to the market move - you could lose your premium. But the crop you hope to harvest and sell will also gain value with the market rise. You cannot lose more than the premium you paid per bushel.

However, if the market drops, your premium gains value as the market falls, again, roughly equivalent to the drop in the market.

So what you did is fix your value very close to the strike price you chose, while leaving your upside completely open in case of a big swing higher.

That's how you protect your downside price risk.

It's not a real easy concept to grasp initially, but using an example might help:

Your soybeans look like they will produce about10,000 bushels, so you might want to buy 2 contracts of 5,000 bu/each to cover them.

The November contract is trading at $12.00, so you decide to stay right "at the money" and choose a $12.00 strike price. The CBOT $12.00 strike for put options is trading at .60 cents per bushel, so your contracts cost you $3000.00 each. That's a fair chunk of change, but you have to think of it as buying an insurance premium - your premium guarantees you the right to sell 10,000 bu of soys at $12.00/bu, no matter how far the board price drops.

Scenario #1 : Oh man, the weather turns dry in the corn belt and the US crop is cut sharply and the market goes up to $14.00/bu.!!! what does that do to your put option? It makes it drop to no value because who want to buy your right to sell beans at $12.00 per bushel when the market is selling them for $14.00? No one. So you lost your .60/bushel premium, but the value of your crop in the field went up $2.00/bu and that more than offsets your lost premium.

Scenario #2: Well, after a bad start, the US corn belt turns into the Garden of Eden this summer and it looks like a record crop and the board is dropping faster than greased lightning all the way down to $9.00/bu. from the earlier $12.00 mark.

But you had bought a November $12.00 put option for around .65 cents/bu., giving you the right to sell your contract amount at $12./bu.

Now, of course, everybody wants to buy your $12.00 put option. So, the price (the premium paid) of your option goes up about the same amount as the board price dropped, making your option now worth about $3.00/bu. Makes your .65 cent premium looks pretty good!

Of course, your crop in the field or in storage dropped the same amount, but your put option value will roughly offset the loss you suffered in your actual crop.

The worst thing for options is a flat market - your option looses its value and the market went neither up nor down. Options require volatility to make them work.

OTOH, if you sold your crop and want to keep your upside open, you buy call options which work exactly the same way, but in the opposite direction.

After I reread this, I decided that if you can follow this, you could work for the FBI.

Hope this helps. It's been a long time since I dabbled in this racket. And I have no intentions of going back to them.

[farming101]

Good work Burnt.
A couple of other things:
Your broker will charge a commission fee.
You can sell your options before expiry date.

[burnt]

So much that I missed - the one important one - in the 2nd scenario, when the market dropped and your put option rose in value, you then sell your put option for its market value - likely it will be your original premium value (roughly, but not necessarily exactly) plus how ever much the market dropped.

There are other factors and variables that affect its exact value, but the increase in the value of your put option is where you cover the losses you experienced in your actual crop value.

As I said - it's not something that many people grasp in their first lesson. I greatly enjoyed the marketing courses I took and there is so much to learn. This barely scratches the surface of options and what you can do with them.

[Oliver88]

What option would be a good idea for Minneapolis/Chicago wheat on October 31st?

What option would be a good idea for canola or soybeans on October 31st?

It would be good to see a few examples for tomorrow’s market.

[errolanderson]

For cash canola sales replacement, March canola $500 calls are trading at $10/MT or lower this week. May canola $500 calls may trade around $15/MT. These May calls are slightly in-the-money. Premiums for both calls and puts appear quite reasonable for canola given lack of market volatility.

For growers selling their feed wheat or barley this fall, May corn (at-the-money) calls are also quite affordable due to quiet volatility. Note: once market volatility picks up, premiums for both puts and calls will get more expensive.

[farmaholic]

That's quite the nutshell burnt.

[farming101]

If speculating with unpriced canola in the bin is your game loading up on Jan 485 puts would be a fairly cheap way to take some of the sting out of a further drop in price. $5.50/tonne

Wheat - getting some moving out of the bin and replacing with calls might be the way to go. I would risk waiting a few more weeks to see if they get a little cheaper Chicago Mar 530 calls 18 3/4 cents

[burnt]

Errol - what essentials did I miss? :-/

[bucket]

A question ....you said.....


The November contract is trading at $12.00, so you decide to stay right "at the money" and choose a $12.00 strike price. The CBOT $12.00 strike for put options is trading at .60 cents per bushel, so your contracts cost you $3000.00 each. That's a fair chunk of change, but you have to think of it as buying an insurance premium - your premium guarantees you the right to sell 10,000 bu of soys at $12.00/bu, no matter how far the board price drops.


If you paid 60 cents to get $12 then isn't your net on that bushel $11.40 ??????

[macdon02]

A question ....you said.....


The November contract is trading at $12.00, so you decide to stay right "at the money" and choose a $12.00 strike price. The CBOT $12.00 strike for put options is trading at .60 cents per bushel, so your contracts cost you $3000.00 each. That's a fair chunk of change, but you have to think of it as buying an insurance premium - your premium guarantees you the right to sell 10,000 bu of soys at $12.00/bu, no matter how far the board price drops.


If you paid 60 cents to get $12 then isn't your net on that bushel $11.40 ??????

Only if you let it go to expiry. The premium paid is based on time value and intrinsic, the possibility it'll go higher. So ideally you buy calls on a move down, lowering the possibility of an up move, and vice versa on puts. 85% of options expire worthless. You don't want to be selling when the market is working against you... ideally

[macdon02]

Cargill and viterra have programs you can use to "hedge". You can't be double long using these and they take a larger commission then a broker would. The paperwork to set up an account through a brokerage is very easy, although lengthy and any decent broker will walk you through it. With online banking it's just a couple clicks to fund. Taxes..... well the losses are deductible. I don't recommend holding into expiry, look to exit approximately 30 days or more prior. I'm holding July Canola calls and planning on dumping into the spring rally, no later then first week of June, they expire June 21. The number of blown out accounts is something like 91% over 5 yrs as far as getting rich is concerned..... having said that it does provide a producer flexibility that you can't get anywhere else. I highly recommend selling physical before buying the calls(prevents double long, remember all next yrs production is "long" until sold as well). I won't discourage anyone from trying it, just use moderation and get educated. You'll want to get to know seasonal charts. Have a realistic target in mind and don't deviate from it, ie $.50-$1. The best decisions are the hardest to make, if you know that feeling it'll keep you safe and put money in your jeans(rejecting greed, makes my skin crawl but serves a person well). It's over 3 yrs now in canola since the low and we haven't taken it out, this up move is no longer a reaction. We are setting trend on a yearly level.

[errolanderson]

Errol - what essentials did I miss? :-/

burnt . . . good job

The key about options is it is an extension of your marketing toolbox. For example, for growers wanting to move their canola due to storage issues and inject cashflow into your business, sell the cash canola and replace with calls as a consideration. If canola continues to drop, you'll be glad you sold the cash. If South American throws us a weather scare, ICE canola futures would climb.

Let's say, you buy March $500 calls at $10/MT and the March contract rallies to $530/MT in January. Your calls would be worth . . . March futures $530 - March strike $500 = $30 plus time and volatility. If canola is suddenly volatile, your call premium may reflect a further $5 to $10 extra pushing premium to $35 to $40/MT

Less say you sell the March $500 call at $35/MT during this rally - premium paid of $10 = $25/MT gain minus brokers commission.

If March canola drops to $480/MT, your call option would expire worthless. If there is time left before expiry, there may be some value left in call option to sell, but you will be glad you banked your cash canola already.

Puts are just the reverse . . . you are guarding the downside. In my career, our largest gains by clients have been owners of put options. This is a hedge. Best time to purchase puts is during a heated bull rally. No one knows where the top is, we just know the rally won't hold. Scaled-up put buying program during weather markets is a strong marketing strategy. Remember, markets tend to step up and then take an elevator ride down . . . .

all the best with your marketing . . . .

[ajl]

I find options premiums on grain markets quite high so they will not pay for the average producer. If you are a large farmer and can afford margin money, you are better off to write calls on rallies or puts on sell offs. That way you pocket the premiums. I do some covered call writing on stocks, which is easier and more efficient for a small trader. Best way to make money on the TSX. Currently short BCE november @56. Canuskistan has a zombie economy.

[burnt]

I find options premiums on grain markets quite high so they will not pay for the average producer. If you are a large farmer and can afford margin money, you are better off to write calls on rallies or puts on sell offs. That way you pocket the premiums. I do some covered call writing on stocks, which is easier and more efficient for a small trader. Best way to make money on the TSX. Currently short BCE november @56. Canuskistan has a zombie economy.

I have known guys that did that, and with some success, or so they said.

However, I could never understand how that could be seen as reducing risk (if that's the objective), but rather saw it as double exposure to the market forces.

It would/could work if you are watching every move and ready to pull the trigger is things start to go against your hedge, or are using fairly tight stops.

Writing options has unlimited risk, in my understanding. Certainly only for the stout of heart.

But I agree that the premiums are high, when weighed against the payback especially. So for that reason, someone is making money in writing that option.