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“There are 2 types of options on futures, put options and call options. An option is a subset of the futures market and each option is specific to a certain commodity, futures month and price for that commodity,” explains Neil Blue, provincial crops market analyst with the Alberta government.
“Options are similar to insurance in several ways, including some of the related terminology. Put options bought or sold through a commodity futures broker do not have a physical delivery commitment attached to them. Some grain companies offer contracts that use options, but those contracts generally contain a physical delivery obligation.”
Purchasing a put option gives the buyer of that option the right, but not the obligation, to enter into a ‘sell’ futures position at a predefined price within a certain time. At the buyer’s option, this right can be ‘exercised’ (that is, turned into the futures position) anytime before that option’s expiry date, and regardless of what the futures price of that commodity does.
As a hedge, buying a put option locks in a minimum futures price at a cost, the premium. For example, a canola producer could buy a put option to protect against futures price downside from a selected price level, the strike price. Strike prices are set at regular price intervals, $5/tonne increments for canola options.
“Buying a put option leaves the price upside open since, with an option, you can lock in the futures price at the selected strike price of that put option, but you don’t have to,” explains Blue.
If the canola futures price rises while the put option is owned, you can still price canola against the now higher futures price. Meanwhile, the put option value will drop since it contains the right to sell canola futures at what is now a less attractive strike price. Alternatively, if the canola futures price drops, put option values will increase.
“The optional aspect of an option is an important difference from a sell futures strategy, which absolutely locks in a specific futures price. Other distinctions of buying an option compared to a futures position are that the option premium paid (plus commission) is the maximum cost of guaranteeing a minimum futures price, and there are no margin calls when you buy an option.”
Put option purchase example
This example uses numbers from the canola futures market for June 17, 2022, with the size of each canola option contract the same as that of the futures contract, 20 tonnes.
November 2022 canola futures= $1020/tonne
November 2022 $980 put option premium= $60/tonne
“Purchasing the November 980 put option for $60/tonne (plus about $1/tonne commission) would give you the right to create a sell futures position in your futures account at a price of $980/tonne anytime up to expiry of that option in late October, and regardless of the November canola futures price,” explains Blue. “It is this right that gives the option its value.”
The premium of an option will change as the futures price changes, as time passes, and in response to price volatility of the underlying futures contract to which that option relates.
“Using this example, you could say that, excluding commission, buying that November 980 put option locks in a minimum futures price of $920/tonne ($980 option strike price minus $60 premium). That premium is high, but so is the price downside risk. Note that after buying an option, instead of exercising it, you could sell it as an option anytime for the open market trading value, which may be more or less than what you paid for it.”
If the futures price falls, the premium of the $980 put option will tend to rise, which would provide a cushion to lower cash prices. Alternatively, if the futures price rises, the value of the $980 put option will fall. However, if the futures price rises, it is likely that the value of physical canola is also rising.
“In summary, as a canola producer, using a put option can provide some protection from a price drop while retaining flexibility to take advantage of a higher price and still shop for the best buyer in terms of basis and grade. Buying a put option will cost a premium plus some commission, but that cost is the maximum risk of buying an option. It is one of the marketing alternatives to consider,” says Blue.
For more information, see:
Contact
For more information, connect with Neil Blue at 780-422-4053.
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