Table of contents

    1. Seven Steps to Better Marketing
    2. Understanding supply factors for agricultural products
    3. How demand and supply determine market price
    4. How exchange rates affect agricultural markets
    5. How interest rates affect agricultural markets
    6. How to use charting to analyse commodity markets
    7. Agriculture marketing clubs
    8. Commodity futures markets
    1. Economics and Marketing – Choosing a Commodity Broker
    2. Margin on futures contracts
    3. Options on futures – an introduction
    4. Using hedging to protect farm product prices
    5. Canola futures contract
    1. Introduction to crop marketing
    2. Basis – How cash grain prices are established
    3. Grain marketing decision grid
    4. Price pooling – How it works
    5. Crop contracts
    6. Grain storage as a marketing strategy
    7. Using producer cars to ship prairie grain
    8. Using frequency charts for marketing decisions
    9. Western Canadian grain catchment
    10. Barley and wheat marketing resources
    11. Wheat basis levels
    12. Wheat quality and protein matters
    13. Wheat pricing considerations
    14. Marketing oats in Canada
    15. US Crops – Where Are They Grown?
    1. Introduction to livestock marketing
    2. Understanding and using basis levels in cattle markets
    3. Forward contracting of cattle
    4. Understanding dressing percentage of slaughter cattle
    5. Understanding the cattle market sliding scale
    6. Predicting feeder cattle prices
    7. Breakeven analysis for feeder cattle
    8. Farm gate values for farm-raised vs purchased calves
    9. Wool marketing in Canada
    10. Marketing feeder lambs
    1. Turf and forage seed trade companies active in the Peace Region
    2. History of creeping red fescue production in the Peace River Region
    3. Alfalfa seed marketing in Canada
    4. Forage seed marketing
    5. Marketing creeping red fescue
    6. Faba bean
    7. Marketing compressed hay
    1. Agricultural Marketing Glossary – A, B
    2. Agricultural Marketing Glossary – C
    3. Agricultural Marketing Glossary – D, E
    4. Agricultural Marketing Glossary – F, G
    5. Agricultural Marketing Glossary – H, I, J, K
    6. Agricultural Marketing Glossary – L, M
    7. Agricultural Marketing Glossary – N, O
    8. Agricultural Marketing Glossary – P, Q, R
    9. Agricultural Marketing Glossary – S
    10. Agricultural Marketing Glossary – T, U
    11. Agricultural Marketing Glossary – V, W
    12. Other Marketing Related Glossaries

Introduction

An option is a subset of the futures market, and each option is specific to a certain commodity and futures month for that commodity. Options are similar to insurance in several ways, including some of the related terminology. Options bought through a commodity futures broker do not have a physical delivery commitment attached to them.

Some grain companies offer contracts that use options, although those handled by a grain company generally contain a physical delivery commitment.

Types of options

There are 2 basic types of options on futures: put options and call options:

Put options

An option is a choice. 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, that is, the strike price, within a certain time period. 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.

From a hedging point of view, 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 price downside from a certain price level. Buying a put option leaves the price upside open since, with an option, you can lock in the predetermined futures price, but you do not have to.

If the price of canola rose during the time that the put option was owned, the canola producer can still sell canola at the higher price. Meanwhile, as the futures price rose, the value of the right to sell canola futures at the fixed option price level will drop, and the premium paid for that option may be lost.

This optional aspect of an option is an important difference from a sell futures position, which locks in a certain futures price.

Another important distinction of buying an option compared to having a futures position is that the option premium paid plus commission is the maximum cost of guaranteeing a minimum price. There are no margin calls when you buy an option.

Put option example

Here is an example of a put option purchase using numbers from the ICE Canada canola market.

  • March canola futures: $515 per tonne
  • March $520 put option premium: $26 per tonne

Purchasing the March $520 put option for $26 per tonne, plus about $1 per tonne commission, would give you the right to create a sell futures position in your futures account at a price of $520 per tonne anytime up to expiry of that option in late February. It is this right that gives the put option a value.

The premium of the option will change as the futures price changes, as time passes, and in response to volatility in the underlying futures contract to which that option relates.

Call options

Purchasing a call option gives the buyer of that option the right, but not the obligation, to enter into a buy futures position at a predefined price, that is, the strike price. This right can be exercised anytime before that option's expiry date, and regardless of what the futures price of that commodity does. From a hedging point of view, buying a call option locks in a maximum futures price.

For example, a canola crusher could buy a call option to protect against price upside above a certain price level. Since exercising the call option is optional, if the price of canola falls, the crusher could just let the call option expire and buy open market canola at the lower price.

Another use of a call option is for replacement strategy. For example, a farmer delivers and prices some canola. Believing that the futures price will rise, the farmer buys call options on a similar quantity of canola to that sold physically. By doing so, he can benefit from a potential rise in the futures market, thus adding value to the canola already sold.

By using the call option purchase for this strategy, risk is limited to possible loss of the premium paid for that call option. Meanwhile, he has the majority of the proceeds from the canola sale and has reduced risk of spoilage and theft on the quantity of canola sold.

Call option example

Here is an example of a call option purchase using numbers from the ICE Canada canola market.

  • May canola futures: $509 per tonne
  • May $510 call option premium: $27 per tonne

Purchasing the March $510 call option for $27 per tonne, plus about $1 per tonne commission, would give you the right to create a buy futures position in your futures account at a price of $510 per tonne anytime up to expiry of that option in late April. It is this right that gives the call option its value.

After you buy

If you buy an option, there are 3 ways to deal with that option:

  1. You can exercise the option, that is, create the specific futures position that buying the option has given you the rights to do. To do this, you would just ask your broker to exercise your option. When that is complete, you no longer own an option, but now have a new futures position. If you exercise a put option, you will create a sell futures position in your account; if you exercise a call option, you will create a buy futures position in your account. The specific futures position created will be determined by the characteristics of the option that you owned. Using the canola put option in the previous example, exercising the March $520 put option would create in your account a sell position in March canola futures at a price of $520 per tonne.
  2. You can sell the option as an option for its premium, which might be greater or less than the premium when you purchased that option. This alternative is often the best choice. You can sell an option anytime that futures and options are trading. You may be able to capture some option premium that would be lost when exercising the option or letting the option expire. Brokerage commissions to sell an option are usually less than when you exercise the option.
  3. If you hold the option until the end of its life, it may not have any remaining premium. When the remaining option premium is less than the brokerage cost to sell that option, then you would just let the option expire. Like insurance, in letting an option expire, you could consider that the option provided specific protection, that is, price, while you owned that right, but you did not have a claim before the term of that price risk coverage ended.

Option premium

There are 2 parts to an option premium: intrinsic and time value.

Intrinsic value is what the option would be worth as a futures position if the option was exercised. For example, there would be intrinsic value in the March $520 put option whenever March canola futures are below $520 per tonne. With March futures at $515 per tonne, there would be $5 per tonne of intrinsic value in the March $520 put option. Of the total option premium of $26 per tonne, when March futures are $515 per tonne, there is $5 per tonne of intrinsic value and $21 per tonne of time value.

Time value is sometimes referred to as risk premium. Two main factors affect time value, and they are time itself, and volatility of the underlying futures price. Both of these factors are elements of risk:

  • the longer the option life, the greater the risk to someone selling that option
  • the more volatile the underlying futures contract, the greater the risk to someone selling that option

Note that, if an option is exercised, any remaining time value in that option is immediately extinguished. Until expiry of the option, there is usually some time value in an option, so it is better to capture some return of that time premium by selling the option rather than exercising it.

The premium or value of an option is subject to change by open market trading whenever the futures market is trading. Canola option strike prices are $5 per tonne apart, so there are many strikes prices available. On days when a particular option strike price does not trade, the commodity exchange uses a computer program to estimate the daily settlement value of that option.

Hedge example – Put option

The purchase of a March $520 canola put option at a cost of $26 per tonne, plus commission, can be interpreted as locking in a minimum futures price. If the entire premium or cost was eventually lost, buying that option can be considered as locking in a minimum March canola futures price of $493 per tonne ($520 strike price minus the $26 per tonne premium minus $1 per tonne commission). If the futures price falls from $515 per tonne, the premium of the $520 put option will tend to rise.

Alternatively, if the futures price rises, the value of the $520 put option will tend to fall. But, if the futures price rises, it implies that the value of physical canola is also rising. If the option is kept to expiry, and if then the option has intrinsic value, that is, March futures is below $520 per tonne, the $520 put option would be automatically exercised, thus creating a profitable March canola futures sell position, not considering the original cost of the option. That sell futures position would then have to be offset at some time before the March canola futures expires.

Flexible delivery commitment

Buying an option through a commodity futures broker leaves the basis portion of price open. That can be a good thing if basis levels for the expected delivery period are considered too weak to lock in, or if one does not want at the time to commit to a physical sale to a certain buyer.

The put option is an attractive alternative to crop producers who are concerned about committing to a delivery with the possibility of a crop shortfall (on quantity or quality), to those producers who have already forward contracted with physical buyers to their comfort level or to producers who wish to retain the ability to take advantage of possible higher prices.

Summary

A first step in planned marketing is to know your costs of production for a crop, and then use that information as a base for establishing profitable price targets as part of a marketing plan.

As a crop producer, using a put option can provide 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.

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