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For more than 130 years, the KCBT's wheat futures contract has provided a risk management tool that contributes to the smooth, efficient flow of wheat from field to table. With its wheat options contract, first traded in 1984, the exchange offers yet another form of risk management for producers, handlers and processors of hard red winter wheat.
Options strategies can be complex but the idea behind them is simple-an option is price insurance that provides protection and profit potential.
Options are used by a variety of people, using a variety of strategies. The key is flexibility.
This page explains some of the trading opportunities available in wheat options at the Kansas city Board of Trade. Included are definitions of basic terms, as well as examples of possible options strategies for various segments of the grain industry.
WHO USES OPTIONS?
Options users are a diverse group. They include wheat growers, country elevators, mills, exporters, feedlots and multinational grain companies who limit their price risk by hedging. They also include investors who are willing to accept risk in exchange for profit opportunities. Without both hedgers and investors, there would be no options market.Farmers use options as insurance against price declines for wheat in the field or bin, or to benefit from price increases if the wheat has been sold. Grain handlers and feedlots use options for protection against adverse price moves or to maximize profits.
Options provide insurance at a fixed cost the buyer knows ahead of time, similar to a policy for life, health or hail insurance. They provide marketing flexibility by offering a variety of risk-reduction strategies to anyone whose livelihood is affected by the price of wheat.
For those with risk capital to invest, options provide a vehicle to enhance profit opportunities.
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WHAT IS A WHEAT OPTION?
A wheat option is a contract that gives an investor the right to buy or sell a wheat futures contract at a specific price (called the "strike price") within a certain time period. The right to buy the wheat (go long the futures) is a "call" option, and the right to sell the wheat (go short the futures) is a "put" option.
Calls and puts are traded separately. This means that for every call buyer, there is a call seller, and for every put buyer, there is a put seller. Calls and puts are not the opposite sides of the same transaction.
In options trading, the choice belongs to the buyer. An option buyer may choose to exercise the option by taking the futures position, but is not required to do so. The buyer also may choose to offset his position by selling the option. If the buyer chooses not to exercise or offset, the option simply expires.
For an option buyer, the maximum amount at risk is the premium, or the cost of the option. The premium is discovered in the options pit through open outcry of competitive bids and offers.
The option seller, or writer, receives the premium from the buyer. For that premium, the option writer may be required to take an opposite wheat futures position if the buyer exercises. The writer must also put up additional money if prices move against his position. For an option writer, the amount at risk is unlimited.
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WHAT IS A PREMIUM? HOW IS IT DETERMINED?
The premium is the purchase price a buyer pays for the option. It is discovered by open outcry on the KCBT trading floor, based on competitive bids and offers. Paying the premium is the option buyer's only obligation.Premiums are influenced by supply and demand for the commodity itself. They reflect how much the option buyer is willing to pay and how much the seller will accept.
Two factors buyers and sellers consider when agreeing on a premium are intrinsic value and time value.
Intrinsic value is the dollar amount, if any, that could be realized if the option were exercised immediately. Intrinsic value is determined by comparing the option strike price with the current price of the wheat futures contract. If the option has intrinsic value, it is "in the money."
For example, if July futures are trading at $3.40, a July call option with a strike price of $3.30 would be 10 cents in the money, as follows:
The call buyer could exercise by taking a long July futures position at the $3.30 strike price and immediately sell the futures at the $3.40 market price, realizing a 10-cent profit.July futures: $3.40
July $3.30 call: -3.30
"In the money" $.10
Conversely, an option is "out of the money" if it has no intrinsic value. A call with a strike price above the current futures price is out of the money; a put with a strike price below the current futures price is out of the money. An option with a strike price equal to the futures price is "at the money."
July futures: $3.20
July $3.30 call: -3.30
"Out of the money" $-.10
July futures: $3.30
July $3.30 call: -3.30
"At the money" 0
The higher the intrinsic value, the higher the premium is likely to be.
The other factor influencing premiums is time value. Time reflects the probability that prices will change between now and the exercise date. The more time remaining until expiration, the greater the probability prices will fluctuate and the greater the time value component of the premium.
The following example illustrates this point.On July 23, market prices are as follows:
September futures: $2.50
September 2.50 call: 6.5 cents (premium)
September 2.50 put: 6.5 cents (premium)
The options are at the money, so the entire premium comprises time value.
On that date, 17 days remained until the September options expired.
Contrast the September premiums with the December premiums on the same
date:
December futures: $2.58
December 2.50 call: 17 cents (premium)
December 2.50 put: 17.5 cents (premium)
The call has 8 cents of intrinsic value ($2.58-$2.50), with 9 cents remaining
as time value. The put is 8 cents out of the money ($2.50-$2.58), so the
entire premium is time value. On that date, about four months remained until
the December options expired.
Because the December options have more time remaining until expiration,
the time values in these premiums are greater than the time values in the
September premiums.
In addition to the time remaining until expiration, time value reflects the underlying commodity's price volatility, or the risk of price change.
If prices tend to fluctuate sharply from day to day or week to week, there is a greater risk that an option could move in the money. The option writer would require a larger premium to compensate for that risk.
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HOW ARE OPTIONS EXERCISED?
A buyer exercises an option when he decides to buy or sell the underlying commodity by taking a futures position. If he exercises a call, he will buy (go long) the underlying futures contract at the call's strike price. If he exercises a put, he will sell (go short) futures at the put's strike price. A buyer would choose to exercise an option only if prices moved in the direction he anticipated when he purchased the option. If prices moved unfavorably, the buyer would simply allow his option to expire without exercising it, forfeiting only the premium.Options are exercisable at any time prior to the expiration by giving notice of exercise to the Clearing Corporation by 4:00 p.m. Central time on any trading day, up to and including the last trading day. A buyer wishing to exercise should consult his broker for the specific deadline.
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WHAT IS A FUTURES CONTRACT?
A futures contract is an agreement to make or take delivery of wheat on a future date at a price negotiated between buyer and seller.
At the Kansas City Board of Trade, a wheat futures contract is for 5,000 bushels of No. 2 hard red winter wheat delivered in Kansas City. Wheat graded No. 1 and No. 3 can be delivered at differentials established by the exchange.
The futures trader may fulfill his obligation to make or take delivery by "offsetting" his position: a futures buyer (long) would sell his contract, and a seller (short) would buy back his contract. Price changes that occur between the time a position is established and offset determine the profit or loss of the trade.
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HOW ARE WHEAT OPTIONS OFFSET?
An option buyer does not necessarily need to exercise an option to realize a profit. Instead, the buyer may choose to liquidate his position by offsetting, or selling, the option on or before the last trading day. A seller can offset by buying the option back.If the option's value has increased, the buyer who offsets will realize a profit. If the option's value has decreased, the buyer who offsets may be able to recover some of the original premium paid, reducing his loss.
This ability to buy and sell the option without becoming involved in the futures market enhances the option's flexibility as a marketing tool.
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ADVANTAGES AND DISADVANTAGES
Advantages
| Hedging in Futures | Buying Options | Writing Options |
| (1.) Reduces price risk | (1.) Reduces price risk | (1.) Generates income from premium received |
| (2.) Offers marketing flexibility | (2.) Offers marketing flexibility | (2.) Offers marketing flexibility |
| (3.) Known cost; risk limited to premium | ||
| (4.) Maintains profit potential | ||
| (5.) No margin account needed; no margin calls | ||
| (6.) No further action required, but may be offset or exercised if advantageous |
Disadvantages
| Hedging in Futures | Buying Options | Writing Options |
| (1.) Margin account needed; subject to margin calls | (1.) Must pay premium up front | (1.) Margin account needed; subject to margin calls |
| (2.) Must perform on contract or offset | (2.) Premium may be lost if option expires worthless | (2.) May be required to perform if option is exercised |
| (3.) Profit potential limited as is loss potential | (3.) Risk unlimited if price moves adversely | |
| (4.) Profit limited to premium; no potential for further gains from option position |
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HOW ARE OPTIONS USED?
THE PRODUCER
Situation:On April 1, a wheat producer expects to harvest 10,000 bushels in July. September futures, on which his cash price at harvest will be based, currently are trading at $3.30. The producer expects prices to fall by harvest and wants protection against a declining market. On the other hand, the producer does not want to sell now on forward contract in case prices move higher.
Marketing Choice without Options:
Sell now and lose profit potential, or sell later and risk a price drop.
The Options Alternative:
Buy two at-the-money September $3.30 puts for a premium of 10 cents a bushel. The producer now has the right to sell 10,000 bushels of wheat at $3.30 per bushel any time before the options expire. The producer's minimum price is $3.30 less the 10-cent premium, or $3.20.
September futures: $3.30
September put option: $3.30 per bushel,
10-cent premium
Results:
Following are potential results at various futures price levels on July 15:
| Futures Price | - | Premium Cost (bu.) | + | Option's Intrinsic Value (Strike-Futures) | = | Net Price Received | Net Price without Option |
| $3.50 | - | .10 | + | 0 | = | $3.40 | $3.50 |
| $3.40 | - | .10 | + | 0 | = | $3.30 | $3.40 |
| $3.30 | - | .10 | + | 0 | = | $3.20 | $3.30 |
| $3.20 | - | .10 | + | .10 | = | $3.20 | $3.20 |
| $3.10 | - | .10 | + | .20 | = | $3.20 | $3.10 |
| $3.00 | - | .10 | + | .30 | = | $3.20 | $3.00 |
| $2.90 | - | .10 | + | .40 | = | $3.20 | $2.90 |
Note that the minimum price received with options is equal to the strike price selected less the premium paid ($3.30- .10=$3.20).
The producer who bought the put has locked in a minimum price
of $3.20, but has not eliminated his potential to gain if prices increase.
The producer who does not buy the put saves the premium cost if prices
increase, but has no downside protection.
(This example does not account for basis or commission fees.)
Another Options Alternative:
The flexibility of options is not limited to one strategy. The
producer in this situation could also choose to sell on forward contract
now to lock in a cash price, and could buy two September calls to take
advantage of any future price increases.
The producer buys two out-of-the-money September $3.40 calls for a premium
of 6 cents a bushel. If prices move above $3.40, the producer can exercise
or offset the options any time before they expire, profiting from the
higher prices even though he sold his crop on forward contract.
September futures: $3.30
September call option: $3.40 per bushel,
6-cent premium
Results:
Following are potential results at various price levels on July 15:
| Futures Price | Forward Contract Price Received | - | Premium Cost (bu.) | + | Option's Intrinsic Value (Futures-Strike) | = | Net Price Received | Net Price without Option |
| $3.80 | $3.30 | - | .06 | + | .40 | = | $3.64 | $3.30 |
| $3.70 | $3.30 | - | .06 | + | .30 | = | $3.54 | $3.30 |
| $3.60 | $3.30 | - | .06 | + | .20 | = | $3.44 | $3.30 |
| $3.50 | $3.30 | - | .06 | + | .10 | = | $3.34 | $3.30 |
| $3.40 | $3.30 | - | .06 | + | 0 | = | $3.24 | $3.30 |
| $3.30 | $3.30 | - | .06 | + | 0 | = | $3.24 | $3.30 |
| $3.20 | $3.30 | - | .06 | + | 0 | = | $3.24 | $3.30 |
| $3.10 | $3.30 | - | .06 | + | 0 | = | $3.24 | $3.30 |
Note the minimum price with options is equal to the forward contract price less the premium paid ($3.30- .06=$3.24).
The producer who bought the call has locked in a minimum price
of $3.24, but has not eliminated his potential to gain if prices increase.
The producer who does not buy the call saves the premium cost, but has
eliminated his potential to gain if prices increase.
(This example does not account for basis or commission fees.)
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HOW ARE OPTIONS USED?
THE COUNTRY ELEVATOR
Situation:
On June1, a country elevator merchandiser sells 50,000 bushels
of wheat to a local feedlot for September-November delivery. December
futures, on which the flat prices sale was based, are trading at $3.10.
The merchandiser does not want to buy wheat now to cover the sale because
he thinks prices will move lower. On the other hand, he wants protection
in case prices move higher.
Marketing Choice without Options:
Buy now and lose the potential for extra profit if prices decline,
or wait and risk a loss if prices go up.
The Options Alternative:
Buy 10 out-of-the-money December $3.20 calls for a premium of 20 cents
a bushel. The merchandiser now has the right to buy 50,000 bushels of
wheat at $3.20 per bushel any item before the options expire. The merchandiser's
maximum price is $3.20 plus the 20-cent premium, or $3.40.
December futures: $3.10
December call option: $3.20 per bushel,
20-cent premium
Results:
Following are potential results at various price levels on October 15:
| Futures Price | + | Premium Cost (bu.) | - | Option's Intrinsic Value (Futures-Strike) | = | Net Price Paid | Net Price without Option |
| $3.60 | + | .20 | - | .40 | = | $3.40 | $3.60 |
| $3.50 | + | .20 | - | .30 | = | $3.40 | $3.50 |
| $3.40 | + | .20 | - | .20 | = | $3.40 | $3.40 |
| $3.20 | + | .20 | - | 0 | = | $3.40 | $3.20 |
| $3.10 | + | .20 | - | 0 | = | $3.30 | $3.10 |
| $2.90 | + | .20 | - | 0 | = | $3.10 | $2.90 |
Note that the maximum price with options is equal to the strike price selected plus the premium paid ($3.20+.20=$3.40).
The merchandiser who bought the call has locked in a maximum buying
price of $3.40, but has not eliminated his potential to benefit from
price declines. The merchandiser who does not buy the call saves the premium
cost if prices decline, but has no upside protection.
(This example does not account for basis or commission fees.)
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HOW ARE OPTIONS USED?
THE BAKER
Situation:
On September 1, a baker books wheat flour in the equivalent of
25,000 bushels for delivery January through March, based on a March futures
price of $3.40. The baker expects wheat prices to increase, and he thinks
he made a profitable purchase. But the baker is concerned that if wheat
prices decline, the value of his flour inventory will also erode, and
he wants to protect his inventory values.
Marketing Choice without Options:
Risk a loss of value if prices decline.
The Options Alternative:
Buy five at-the-money March $3.40 puts for a premium of 10 cents
a bushel. If prices move below $3.40, the baker can exercise or offset
the options any time before they expire, and the resulting profits will
preserve the net inventory value of his flour. The baker's minimum value
is $3.40 less the 10-cent premium, or $3.30.
March futures: $3.40
March put option: $3.40 per bushel,
10-cent premium
Results:
Following are potential results at various futures price levels on December
15:
| Futures Price | - | Premium Cost (bu.) | + | Option's Intrinsic Value (Strike-Futures) | = | Net Inventory Value | Net Value without Option |
| $3.60 | - | .10 | + | 0 | = | $3.50 | $3.60 |
| $3.50 | - | .10 | + | 0 | = | $3.40 | $3.50 |
| $3.40 | - | .10 | + | 0 | = | $3.30 | $3.40 |
| $3.30 | - | .10 | + | .10 | = | $3.30 | $3.30 |
| $3.20 | - | .10 | + | .20 | = | $3.30 | $3.20 |
| $3.10 | - | .10 | + | .30 | = | $3.30 | $3.10 |
| $3.00 | - | .10 | + | .40 | = | $3.30 | $3.00 |
Note that the minimum value with options is equal to the strike price selected less the premium paid ($3.40-.10=$3.30).
The baker who bought the put has locked in a minimum inventory value
of $3.30, but has not eliminated his potential for profit if prices move
up. The baker who does not buy the put saves the premium cost if prices
increase, but has no downside protection.
(This example does not account for basis or commission fees.)
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HOW ARE OPTIONS USED?
THE MILLER
Situation:
On June 1, a miller sells flour to a baker for November delivery
and needs to buy 50,000 bushels of wheat to cover the sale. The miller
does not want to tie up funds or pay storage by buying the wheat now.
On the other hand, he expects December futures, on which his wheat purchase
price will be based, to move above the current level of $3.35, and he
wants protection against a rising market.
Marketing Choice without Options:
Buy now, tying up funds, or wait until later, and risk a price
increase.
The Options Alternative:
Buy 10 in-the-money December $3.20 calls for a premium of 19 cents
a bushel. The miller now has the right to buy 50,000 bushels of wheat
at $3.20 per bushel any time before the options expire. The miller's maximum
price is $3.20, plus the 19-cent premium and the 30-cent local basis,
or $3.69.
December futures: $3.35
December call option: $3.20 per bushel
19-cent premium
Current basis*: +.30
Current cash price: $3.65
*The basis is the difference between the cash price of wheat at a specific
location and the futures price.
Results:
Following are potential results at various futures price levels on
November 15:
| Futures Price | + | Premium Cost (bu.) | - | Option's Intrinsic Value (Futures-Strike) | + | Basis | = | Net Price Paid | Net Price without Option |
| $3.70 | + | .19 | - | .50 | + | .30 | = | $3.69 | $4.00 |
| $3.60 | + | .19 | - | .40 | + | .30 | = | $3.69 | $3.90 |
| $3.50 | + | .19 | - | .30 | + | .30 | = | $3.69 | $3.80 |
| $3.40 | + | .19 | - | .30 | + | .30 | = | $3.69 | $3.70 |
| $3.30 | + | .19 | - | .10 | + | .30 | = | $3.69 | $3.60 |
| $3.20 | + | .19 | - | 0 | + | .30 | = | $3.69 | $3.50 |
| $3.10 | + | .19 | - | 0 | + | .30 | = | $3.59 | $3.40 |
| $3.00 | + | .19 | - | 0 | + | .30 | = | $3.49 | $3.30 |
| $2.90 | + | .19 | - | 0 | + | .30 | = | $3.39 | $3.20 |
Note that the maximum price paid with options is equal to the strike price selected plus the premium paid, plus the basis ($3.20+.19+.30=$3.69).
The miller who bought the call has locked in a maximum buying price of $3.69, but has not eliminated his potential to gain if prices decline. The miller who does not buy the call saves the premium cost if prices decline, but has no upside protection.
In this example, the basis remains constant. But if the basis has not
been locked in through a basis contract, the maximum price paid will be
subject to changes in the basis. If the basis strengthens, the maximum
price will increase by that amount; if the basis weakens, the maximum
price will decline by that amount.
(This example does not include commission fees.)
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