Colorado Agribusiness Curriculum
Section: / Advanced AgribusinessUnit: / Marketing
Lesson Title: / Options
Colorado Ag Education Standards and Competencies / AGB11/12.04 - The student will understand the influences of agricultural economy and its influences on the overall economy.
Understand the futures market.
Colorado Model Content Standard(s): / Math Standard 1: Students develop number sense and use numbers and number relationships in problem-solving situations and communicate the reasoning used in solving these problems.
Math Standard 3: Students use data collections and analysis, statistics, and probability in problem-solving situations and communicate the reasoning used in solving these problems.
Math Standard 6: Students link concepts and procedures as they develop and use computational techniques, including estimation, mental arithmetic, paper-and-pencil, calculators, and computers, in problem-solving situations and communicate the reasoning used in solving these problems.
English Standard 1: Students read and understand a variety of materials.
English Standard 4: Students apply thinking skills to their reading, writing, speaking, listening, and viewing
English Standard 5: Students read to locate, select, and make use of relevant information from a variety of media, reference, and technological sources.
Student Learning Objectives: / · Student will be able to (SWBAT) Define an option
· SWBAT Understand puts and calls
· SWBAT define strike price and premiums
· SWBAT describe intrinsic value and time value
· SWBAT understanding how options are traded
· SWBAT Understand various option strategies and how they can be utilized for hedging crops or livestock
Time: / 1-50 minute period (worksheet extended days – 3 days)
Resource(s): / Marketing Grain & Livestock, 2nd Edition, by Gary F. Stasko, Iowa State Univers1`ity Press, ISBN 0-8138-2957-7
Strategies for Great Teaching, Mark Reardon and Seth Derner, Zephyr Press Chicago, ISBN 1-56976-178-7
Instructions, Tools, Equipment, and Supplies: / Italicized words are instructions to the teacher; normal style
text is suggested script.
Handouts / PowerPoint Presentation / Quiz
A few bouncy balls
Interest Approach: / Have the bouncy balls in a can or jar. You are going to throw the bouncy balls in the air at different times during this demonstration. You can have a student or two drop or throw the bouncy balls so they will bounce toward the ceiling but choose your students carefully.
Good morning students. We are going to learn today about options in the futures market. Some of you are wondering what the bouncy balls are for. We are going to analyze what happens when I or they throw the ball against the floor. Throw a ball against the floor. What did the ball do? You are looking for the base or lowest part is the floor and it can go no lower. It can bounce up and down—go higher or less high. Do another ball and explain the same concept of a floor yet it can go higher. Now compare this to marketing of your livestock or crops. If you can create a floor and yet not create an up side of the price of this commodity this would be a definite help in your marketing strategies. This way of pricing with a definite floor and allowing for a higher outcome is called the commodity options market.
How are the markets this morning? What are some of the ways that you can be involved in the futures market? Capture these on the board as a review. Is there any way to protect yourself from the rising and falling of prices? Is there any security or insurance in the futures market? Sure there is they are called options.
Objective 1: / Define an option
· Is like purchasing an insurance policy
· It protects you from the unexpected market rise or drop
· You are charged a premium for the service
· You are only financially liable for the premium and not margin calls unless the option is exercised in which it becomes a futures contract and all the rules for futures applies
An option is not necessarily the most profitable method of price protection; however, it does expose you to the least amount of risk.
Objective 2: / Puts
· Gives you the right but not the obligation to sell futures contract
· P is close to S so it means to sell
Calls
· Gives you the right but not the obligation to buy a futures contract
· C is close to B so it means to buy
Objective 3: / Strike Price
· The price at which a holder of an option may exercise it
· These are set prices from the broker
Premiums
· Are traded by open cry in the trading pits
· Two components
o Intrinsic Value
o Time Value
Objective 4: / Intrinsic Values
· Is the amount of money, if any, that could be realized if the option is exercised
· An option is in the money (ITM) if the option has intrinsic values
o If the strike price is below the current futures price
o Example: a soybean call with a $7.00 strike price and the current futures price is $7.50 this call would be ITM
o Example: a Soybean put and the current futures price is $7.50 then the put would be ITM if the strike price is $8.00
· An option is out of the money (OTM) if the option has no intrinsic values
o If the strike price is above the current futures price
o Example: A soybean call with a strike price of $7.00 and a futures price of 6.50 the call is OTM
o Example: a soybean put with a strike price of $7.00 would be OTM if the current futures price is $7.50
· An option is at the money (ATM) if the there is no intrinsic value and the strike price and future price are equal
o Example: a soybean call with a $7.00 strike price and the current futures price is $7.00 the call is said to be ATM
Time Value
· Time and Volatility primarily make up the time value component
· Four Factors
o Actual length of time remaining until expiration
o Volatility of the underlying futures price
o Whether the option is ITM or OTM
o Short term risk free interest rates
Objective 5: / Options give you the right to buy or sell a futures contract at a premium but not the obligation. When you buy or sell a futures contract you are obligated to deliver, take delivery or offset the contract. With an option you pay a premium to have the option to deliver or take delivery if you chose to exercise it or you can let it expire and just pay the premium. Strike prices for options are set but the premium is traded by open outcry just like futures. Again an option gives you the option but not the obligation to deliver, take delivery or let it expire (offset)
Think, Pair, Share
· Break students into groups of two
· Give 1 minute for each student to tell their partner everything they know about options while the other student only listens
· Switch roles and repeat
· Now give the first student 1 minute to tell the other student any questions they have or anything they do not understand while the second student captures these on a piece of paper without saying a word
· Trade roles and repeat
· Ask students to share questions or items that need clarified. Answer these questions and clarify.
Objective 6: / Here is an example of how a producer could use a put option as price protection. Remember, a put option has an underlying right to sell futures and when buying a put, you are establishing a minimum floor price on your commodity. You are not obligated to do anything with the option and if the price decides to raise you can let the option expire and take advantage of the increased prices. If prices decrease, you have the put in place for protection and have established a minimum floor price on your commodity.
Farmer Jim has a target price of $3.00 for his upcoming wheat crop. Options are more appealing to Jim because he knows the cost of the price protection in the beginning and will not have to worry about margin calls. When determining an expected price from using options to hedge, it is exactly the same as when doing it for futures except we also include the premium. So the expected price or minimum floor price for a put would be found by option strike price – premium +/- basis. For example, if Jim is looking at a put with a strike of $3.50 and the option premium of 20 cents and he expects the basis to be 30 cents under, his floor price on the option would be the following:
Option Strike Price $3.50
-Premium -$0.20
- Basis -$0.30
Minimum Floor Price (Expected Price) $3.00
Jim knows, therefore, that in order to reach his target price of $3.00 on his wheat, he will have to probably look at a put strike price of $3.50 or higher. Today’s date is May 1 and the following option strike prices and premiums are available for the August KCBOT HRW wheat contract.
Strike Price / Premium / Basis / Minimum Floor Price
$4.00 / $0.80 / -$0.30 / $2.90
$3.80 / $0.65 / -$0.30 / $2.85
$3.50 / $0.20 / -$0.30 / $3.00
$3.20 / $0.10 / -$0.30 / $2.80
Jim chooses the $3.50 strike price at a premium of $0.20. This option will cost $1000 in total for a 5000 bu wheat contract
Jim has 3 alternatives with his option:
1. Let it expire if the current market price is below his strike price
2. Sell a put option equal to the one he currently holds and collect the premium
3. Exercise the option into the underlying futures contract
On July 10th, Jim is ready to sell his wheat crop. The August KCBOT HRW wheat contract is now currently trading at $3.30. We’ll assume the basis is exactly as he expected of 30 cents under, so the cash price for wheat is currently $3.00.
The following are the options and their premiums available:
Strike Price / Premium
$3.50 / $0.15
$3.30 / $0.02
$3.00 / $0.01
Note the change in premium since May. We know there are two parts to the premium: time value and intrinsic value and the time value is comprised heavily of actual time until expiration and volatility. The time value was much greater in May because of the length of time until August. Now, since we are nearing expiration, the time value is little and volatility makes up the balance.
Jim decides to exercise his $3.50 option. Jim calls his broker and tells him his intentions of exercising his option into a futures contract. After the option is exercised, Jim then immediately buys back the futures contract at $3.30. This nets Jim a gain on his option of 20 cents, but the option costs him 20 cents premium.
Jim sells cash wheat @ $3.00
Gain on option $+0.20
Minus the option premium $-0.20
Net Price Received $3.00
Again, this is a perfect hedge. Basis remained the same and our target price was achieved. In real life, we can always come close to our expected price from hedging with an option if our basis is predicted closely.
Review/Summary: / Options protect you from the unexpected market rise or drop. The two types of options are puts and calls. A put option gives you the right but not the obligation to sell a futures contract and a call option gives the right but not the obligation to buy a futures contract. You can remember this because P is closer to S and C is closer to B. Options are bought by the strike price for a premium. Strike prices are set and are the price at which a holder of an option may exercise it. The premium is traded by open outcry in the trading pits of a futures exchange and is made of two components intrinsic and time values. An intrinsic value is the amount of money, if any, that could be realized if the option is exercised. The intrinsic value of an option is in-the-money, Out-of-the-money, or At-the-money. When an option is ITM is when the strike price is below the futures price. OTM means that the strike price is above the current futures price. When the strike price and the futures price are equal then the option is ATM. The four factors that make up time value are: Actual length of time remaining until expiration, Volatility of the underlying futures price, whether or not the option is ITM or OTM, and short term risk free interest rates. Both put and call options give you the right but not the obligation to sale a futures contract at a set strike price for a premium.
See put and call option strategies example
Application--Extended Classroom Activity: / Options Practice Exercise
Put Options Strategies Exercise
Basis Practice
Purchasing a Put ExerciseBuying a Call at Harvest to Profit from a Winter/Spring Price Increase Exercise
Application--FFA Activity: / Agribusiness Management CDE
Commodity Challenge Activity
Application--SAE Activity: / Have students track futures and options on their SAE
Evaluation: / Homework Assignment
Evaluation Answer Key: /
Homework Assignment Key
Other:
PUT & CALL OPTION STRATEGIES EXAMPLE
- A corn producer who will be selling his crop at harvest wants to establish a minimum floor price by purchasing a put. In May, he buys a December 2.90 put for a premium of 17 cents. The estimated basis for harvest is 22 cents under.
- What would be his minimum floor price:
Strike +/- Basis-Premium=Minimum Floor Price
2.90-.22-.17 = 2.51
- What could he expect for a net selling price for each of the following possible December futures prices if the options were exercised
(Net Price = futures +/- Basis – Premium + intrinsic value if any)
December Futures Net Price
2.71 2.71-.22-.17+.19=2.51
Intrinsic Value on the 2.71 futures would be 19 cents. The put on 2.90 gives you the right to sell at 2.90. You could buy back at 2.71 and make 19 cents so it has an intrinsic value of 19 cents.