Pricing Alternatives for Agrium Managers
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Allan Gray and Chris Hurt, Purdue University
Pricing Alternatives for Agrium Managers
Agrium Regional Meetings
January/ February 2003
Allan Gray and Chris HurtPurdue University, Indiana
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Allan Gray and Chris Hurt, Purdue University
What is an Option?
• Definition: An option is the right, but not the obligation to buy or sell a futures contract at a predetermined price, before expiration.
• Options are derivative instruments. The option is written on an underlying asset -- the futures contract.
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Allan Gray and Chris Hurt, Purdue University
Option Terms
Puts (sell) and Calls (buy)
Strike Price (the price at which the buyer has the option)
Premium (the price of option)
Buyer (has option right) Seller (gives the right)
Expiration Date (buyer has right until expiration day)
Futures July Corn = $2.41 ½
Options ---$2.40 July Corn Call= $ .12 6/8
---$2.40 July Corn Put = $ .14 2/8
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Allan Gray and Chris Hurt, Purdue University
Puts and Calls
• A put option is the right, but not the obligation, to sell an underlying futures contract at a predetermined price prior to expiration.
• A call option is the right, but not the obligation, to buy the underlying futures contract at a predetermined price prior to expiration.
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Allan Gray and Chris Hurt, Purdue University
Strike Price and Premium
• The predetermined price at which an underlying futures contract may be bought or sold is called the strike price or the exercise price.
• The premium is the amount paid for an option. It is the price of the option and is negotiated by open outcry in the trading pit.
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Allan Gray and Chris Hurt, Purdue University
Reading Options Premiums
Corn cents/buJuly Futures = 241 ½ Put Call
Strike Price July July
220 4 1/4 25 1/4
230 7 3/4 19 1/2
240 12 3/4 14 1/4
250 18 3/4 10 1/2
Chicago Board of Trade: January 10, 2003
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Allan Gray and Chris Hurt, Purdue University
Premiums
• Premiums are determined in an open outcry auction. It’s important to realize that all of the options specifications are set by the exchange except for the premium.
• The premium is paid up-front by the buyer, and must be paid whether the option is exercised or not.
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Allan Gray and Chris Hurt, Purdue University
Premiums CompositionOption Premium = Intrinsic Value + Time Value
Intrinsic Value = The immediate positive value if an option were to be exercised
Time Value = The portion of the premium to cover the time until maturity
For the: July Futures = 241 ½ Option Premium = Intrinsic Value + Time Value$2.40 July Corn Call 14 1/4 = 1 ½ + 12 ¾ in
$2.50 July Corn Call 10 ½ = --------- + 10 ½ out
$2.40 July Corn Put 12 ¾ = --------- + 12 ¾ out
$2.50 July Corn Put 18 3/4 = 8 ½ + 10 ¼ in
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Allan Gray and Chris Hurt, Purdue University
The Option Strike in Relation to the Underlying Futures Price
• In-the-money: An option is said to be in-the-money if it has positive intrinsic value.
• Out-of-the-money: An option is said to be out-of-the-money if it
has no (or negative) intrinsic value.
• At-the-money: An option is at-the-money if its strike price is
the same as its underlying futures price.
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Allan Gray and Chris Hurt, Purdue University
Buyers and Sellers
• Pays premium when purchased plus commission
• Receives all the rights
• Does NOT have to margin position
• Knows the maximum costs at the beginning of the trade but the gain potential is unlimited
• Receives premium when sold, minus commission
• Gives all the rights
• Has to margin position
• Maximum gain is know at the beginning of the trade, but potential loses are unlimited and unknown
Buyer Seller or Writer
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Allan Gray and Chris Hurt, Purdue University
Buyers Alternatives
• The buyer of the option may do the following prior to the option expiration:
– Exercise the option and receive the underlying futures,
– Offset the position (Buy a $2.40 July Corn Put is offset
by selling a $2.40 July Corn Put),
– or allow the option to Expire worthless.
• Remember there is No Obligation with an option
purchase!
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Allan Gray and Chris Hurt, Purdue University
Sellers Alternatives
• Option Seller (Writer):
– Receives the premium from the option buyer,
– Must take the opposite position if the option is exercised.
As a result,
– The option seller must post margin money,
– and may face margin calls
– Because they take all of the risk of price change.
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Allan Gray and Chris Hurt, Purdue University
Your Turn
May 03 SoybeanFutures =
Put CallIn/Out
of-the money
Strike Price May 03 May 03
$5.40
$5.60
$5.80
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Allan Gray and Chris Hurt, Purdue University
Similarities of Futures and Options
Futures Options
Legally Binding Yes Yes
Regulated by CFTC Yes Yes
Traded at Exchanges Yes Yes
Broker or cash merchant required
Yes Yes
Expiration date Yes Yes
Can be used to reduce price risk
Yes Yes
Can be used for price speculation
Yes Yes
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Allan Gray and Chris Hurt, Purdue University
Differences of Futures and Options
• Obligation to buy or sell• Can take a position
only at current market price
• Must deposit margin money
• No extra premium charge
• Opportunity, but not obligated to buy or sell
• Can take a position at multiple price levels
• Buyers do not deposit margin money
• Buyers pay a premium, sellers receive the premium
Futures Options
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Allan Gray and Chris Hurt, Purdue University
Why Options over Futures?• Helps overcome Seller’s or Buyer’s Remorse: Which is
the emotion attached to a person taking a position and then seeing the market move in the opposite direction
– Farmers might says: “As soon as I sell the price moves up,” Or they don’t want to price because they have no further opportunity to gain if prices subsequently rise
• Yield Uncertainty: Crop farmers are hesitant to price before they know their yields
• Posting and Managing Margin: Buyers of options do not post margin while futures position holders must.
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Allan Gray and Chris Hurt, Purdue University
6 Pricing Alternatives
Example: Say it’s January 10, 2003 and a producer has 50,000 bushels of corn still in the grain bin and wishes to compare 6 different pricing alternatives for mid-June delivery
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Allan Gray and Chris Hurt, Purdue University
The BIG 6 on January 101. Do no pricing, simply wait and see what prices are in
June
2. Forward price now by selling futures
3. Establish a minimum price by buying a put option
4. Consider a second minimum price level by buying another put strike
5. Establish a maximum price by selling a call option
6. Establish both a minimum and a maximum by buying a put and selling a call.
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Allan Gray and Chris Hurt, Purdue University
Date of Analysis 1/10/03
Futures ExBasis PutStrike 1 PutPrem 1 CallStrik CallPrem
$2.42 -$0.07 $2.40 $0.13 $2.50 $0.11
CommFutr CommPut CommCall Size(bu.) PutSt2 PutPrem2
$50.00 $50.00 $50.00 5000 $2.20 $0.04
Fence Put Prem Fence Call Prem Comm Interval
$2.30 $0.08 $2.50 $0.11 $100.00 $0.10
Input Form
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Strategy# 1 2 3 4 5 6
DoNothing SellFutr BuyPut Buy Put SellCall Fence
2.42 2.40 2.20 2.50 2.30 Buy Put
2.50 Sell Call
Put Premium -0.13 -0.04 -0.08
Call Premium 0.11 0.11
Basis -0.07 -0.07 -0.07 -0.07 -0.07 -0.07
Commission -0.01 -0.01 -0.01 -0.01 -0.02
Adjust to Future -0.07 -0.08 -0.21 -0.12 0.03 -0.06
If Future Move To
$1.82 $1.75 $2.34 $2.19 $2.08 $1.86 $2.24
$1.92 $1.85 $2.34 $2.19 $2.08 $1.96 $2.24
$2.02 $1.95 $2.34 $2.19 $2.08 $2.06 $2.24
$2.12 $2.05 $2.34 $2.19 $2.08 $2.16 $2.24
$2.22 $2.15 $2.34 $2.19 $2.10 $2.26 $2.24
$2.32 $2.25 $2.34 $2.19 $2.20 $2.36 $2.26
$2.42 $2.35 $2.34 $2.22 $2.30 $2.46 $2.36
$2.52 $2.45 $2.34 $2.32 $2.40 $2.54 $2.44
$2.62 $2.55 $2.34 $2.42 $2.50 $2.54 $2.44
$2.72 $2.65 $2.34 $2.52 $2.60 $2.54 $2.44
$2.82 $2.75 $2.34 $2.62 $2.70 $2.54 $2.44
$2.92 $2.85 $2.34 $2.72 $2.80 $2.54 $2.44
$3.02 $2.95 $2.34 $2.82 $2.90 $2.54 $2.44
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Allan Gray and Chris Hurt, Purdue University
Basic Pricing Alternatives
$1.50
$1.70
$1.90
$2.10
$2.30
$2.50
$2.70
$2.90
$3.10
$1.82 $1.92 $2.02 $2.12 $2.22 $2.32 $2.42 $2.52 $2.62 $2.72 $2.82 $2.92 $3.02
If Futures Move To
Net
Fin
al P
rice
Rec
eive
d
Cash Only
Sell Futures
Buy Put #3
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Allan Gray and Chris Hurt, Purdue University
Basic Pricing Alternatives
$1.50
$1.70
$1.90
$2.10
$2.30
$2.50
$2.70
$2.90
$3.10
$1.82 $1.92 $2.02 $2.12 $2.22 $2.32 $2.42 $2.52 $2.62 $2.72 $2.82 $2.92 $3.02
If Futures Move To
Net
Fin
al P
rice
Rec
eive
d
Cash Only
Sell Futures
Buy Put #4
Sell Call #5
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Allan Gray and Chris Hurt, Purdue University
Fence at 1 Strike Above and Below Current Futures
$1.50
$1.70
$1.90
$2.10
$2.30
$2.50
$2.70
$2.90
$3.10
$1.82 $1.92 $2.02 $2.12 $2.22 $2.32 $2.42 $2.52 $2.62 $2.72 $2.82 $2.92 $3.02If Futures Move To
Net
Fin
al P
rice
Rec
eive
d
Cash Only
Sell Futures
Buy Put #4
BuyPut/SellCall #6
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Total $ Returns Above Cost
Acres Yield Total Cost
500 150 $162,750 ($2.17 Total Costs)
Strategy # 1 2 3 4 5 6
DoNothing SellFutr BuyPut Buy Put SellCall BullFence
If Futr $2.42 2.40 2.20 2.50 2.30 Buy Put
Move To 2.50 Sell Call
$1.82 -$31,500 $12,750 $1,500 -$6,750 -$23,250 $5,250
$1.92 -$24,000 $12,750 $1,500 -$6,750 -$15,750 $5,250
$2.02 -$16,500 $12,750 $1,500 -$6,750 -$8,250 $5,250
$2.12 -$9,000 $12,750 $1,500 -$6,750 -$750 $5,250
$2.22 -$1,500 $12,750 $1,500 -$5,250 $6,750 $5,250
$2.32 $6,000 $12,750 $1,500 $2,250 $14,250 $6,750
$2.42 $13,500 $12,750 $3,750 $9,750 $21,750 $14,250
$2.52 $21,000 $12,750 $11,250 $17,250 $27,750 $20,250
$2.62 $28,500 $12,750 $18,750 $24,750 $27,750 $20,250
$2.72 $36,000 $12,750 $26,250 $32,250 $27,750 $20,250
$2.82 $43,500 $12,750 $33,750 $39,750 $27,750 $20,250
$2.92 $51,000 $12,750 $41,250 $47,250 $27,750 $20,250
$3.02 $58,500 $12,750 $48,750 $54,750 $27,750 $20,250
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Allan Gray and Chris Hurt, Purdue University
Which Pricing Alternative to Choose:
Depends Upon
1. Outlook for Prices
2. Costs of Production
3. Risk Bearing Ability
4. Understanding and
Comfort with various
Pricing Alternatives
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Allan Gray and Chris Hurt, Purdue University
Agrium Marketing Software
• The 6 Price Analysis Program is located at:
• http://www.agecon.purdue.edu/staff/gray/agrium/agrium.htm
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Allan Gray and Chris Hurt, Purdue University
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Allan Gray and Chris Hurt, Purdue University
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Allan Gray and Chris Hurt, Purdue University