The following information is bonus material from Top Producer. It corresponds with the article "6 Steps to a Plan” by Linda Smith. You can find the article on page 27 in the Summer 2009 issue.
Sample crop budgets:
GRAIN MARKETING TERMINOLOGY
From Jim Kendrick, University of Nebraska
At-the-money refers to a strike price of an option that is equal to (or nearly equal to) the futures price of that commodity. If January soybean futures were currently priced at $5.25, a January soybean option with a strike price of $5.25 would be an option at-the-money.
The difference between the local cash (spot) price and the closest (nearby) futures contract is commonly referred to as the basis. In October, if the local elevator was paying (bidding) $5.03 for soybeans delivered to the elevator, and the nearby (November) futures contract price was $5.41, the local basis would be "38 under the November” or – 38¢.
The size of the basis depends on the demand for, and the supply of, local storage space. If the local supply of grain is relatively scarce, and the amount of storage available is relatively abundant, then elevators will be aggressive bidders, and the basis will strengthen. But, if grain supplies are abundant and storage space scarce, elevators will be reluctant buyers—and then only at lower prices. Here, the basis will weaken.
Notice that basis can be a negative (cash price less than futures price) or positive (cash price worth more than futures price) value. In grain-deficit areas—the East or parts of the Southeast, for example—local supplies of rain may be short and local buyers would be willing to pay more than the futures price.
Because basis is related to available storage space and the available supply of grain, the traditional basis pattern is for weaker basis levels at harvest, strengthening throughout the crop year as grain becomes scarcer and storage space becomes more available. This normal strengthening of the basis forms the economic rationale for storage. If, for example, the local basis is expected to strengthen by 30¢ during the next 6 months, and the cost of carrying grain for the same period is 24¢, then 6¢ profit can be expected if a basis hedge is established (see "Storage” unit).
In this cash contract, the producer and grain elevator agree upon quantity, quality and delivery period, and "fix” the basis—the difference between the cash and the nearest futures prices. The other component of price—the futures portion—is not set until a later date, up to delivery.
Just as a stock broker buys and sells stocks, a commodities broker buys and sells futures and options on commodities, including grain and livestock. Note that stocks and commodities are not the same thing—companies that "trade” stocks do not necessarily trade in commodities.
In market terminology, a bear is an individual who thinks that prices will go lower. To profit from such a view of market direction, a bear would sell a futures contract or buy a put option. After a bear has taken a position in the market, he/she is said to be "short,” and if prices do in fact move lower, the market is said to be "bearish.”
To sell a nearby contract and buy an equal quantity of a more deferred contract (e.g., to sell January and buy March soybean futures).
A proposal to buy at a specified price or basis. The grain trade often calls a proposal to buy a bid and a proposal to sell an offer.
In marketing terminology, a bull is an individual who thinks that prices will go higher. Thus, a bull would buy either a futures contract or a call option, termed "taking a long position” in the market. One who does so is said to be "long” wheat, corn, soybeans, or whatever. As prices rise, the market is said to be "bullish.”
To buy a nearby contract and sell an equal quantity of a more deferred contract (e.g. to buy March and sell May corn futures).
The purchase of a call option gives the buyer the right, but not the obligation, to obtain a long (buy) futures position at the option's strike price. The buyer pays the premium price for the option, and has no other obligation unless the option is "exercised.” The broker
will normally charge a commission fee of 5% of the premium, or a minimum of $25 but not more than $125 for each option purchased.
The purchase of calls has become a popular strategy for producers who have sold their grain but want to benefit from any price increase, or who wish to protect their deficiency payments.
Assume that you have sold soybeans at harvest for two sound reasons—because the basis was strong, and the market was not providing enough "carry” to make storage of the beans a profitable venture. Yet you believe that there is some probability that soybean prices might increase during the next few months, and you are willing to speculate on that chance. If May soybean futures are currently trading at $5.60, you might consider buying a May call with a strike price of $5.75 for a premium of 10¢. You would pay $500 (10¢/bu. times 5,000 bu.) plus a commission fee of around $35 for the right to obtain a long May soybean futures contract at $5.75. If soybeans never increase from the present level of $5.60, your call will be worthless, and you will have lost $535 on your speculation.
If May futures were to increase to $6 sometime before the option expires, your call would have an intrinsic value of 25¢, in addition to some remaining time value. To realize this gain, you probably would sell the call.
Options expire before the option month (e.g., the December put option on corn would expire in late November).
The cost of storing grain from now until some later time is termed the cost of carry, carry cost, or simply the carry. The cost of carry for producers is made up of three separate costs:
- the fixed costs of the storage facility (say 1¢/bu./mo.)
- the variable costs associated with storage (air, heat, loss of grain condition), which may average around 2¢/bu./mo.
- The opportunity cost associated with the stored grain (tying up money)
See the "Storage” unit for further details.
The clearing corporation is the business entity that matches up all sales and purchases of futures and options each day.
Refers to a short (sold) options position that is backed by owning the cash asset that will rise in value if the option value fails.
The Commodity Futures Trading Commission, the Federal agency that regulates commodity futures trading.
Buyer and seller agree to defer payment until a later time (cf. deferred price).
Deferred price denotes an unpriced grain sale in which title passes upon delivery, but neither the basis nor the futures price is set (cf. deferred payment). Also known as delayed price, no price established.
In mathematics, the Greek letter "delta” stands for change. In options, the delta describes how much the option premium will change when the underlying futures contract increases or decreases in price.
Assume November soybean futures increase from $6.25 to $6.37. Examine the premiums on call options at various strike prices in the following example:
Soybean Option Premiums ($/bu.)
Strike November futures: November Futures:
6.00 .52 .62
6.25 .41 .48
6.50 .31 .36
6.75 .25 .28
Do you see the pattern? At the lower November futures price, the $5 call was priced at 52¢--a 37¢ intrinsic value plus a 15¢ time value. Following a 10¢ rise in price, the premium on the $5 call also increased 10¢--a delta value of 1. The deltas on the other were:
This illustrates that deep-in-the-money options have a delta value near 1; at- or near-the-money options, around 0.5; and out-of-the-money, lower.
If you want penny-for-penny protection against November futures, then a deep-in-the-money call is the one to buy. In this example, a deep-in-the-money call would cost 52¢. If November futures remain at $5.37 until harvest, the $5 call will expire with an intrinsic value of 37¢, meaning that your insurance cost was 15¢.
The $6.50 call would provide about 50% protection if futures rise modestly—say from $6.37 to $6.80. If they remain at $6.37 until harvest, they would expire worthless since the market is below the strike price—you wouldn't want to enter a long futures position (buy soybeans) at $6.50 if you could do so in the open market for $6.37. If futures increase modestly, the $6 call would likely prove to have the cheapest net premium.
To invoke the rights conveyed by owning an option—to take the applicable futures position.
The expiration date is the date on which an option expires. This date is around the 20th of the month preceding the month specified on the contract (November futures, for example, expire in October).
A fence in grain marketing parlance refers to a simultaneous purchase of a put and sale of a call option on the same option month. The objective of this strategy is to reduce the cost of insuring against a price decline, and is a modification of simply buying a put option. In other words, when marketing conditions, your financial situation, and your judgment of future price moves suggest that the purchase of a put option is desirable, a fence provides an alternative.
See the "Option Fence” unit for further details.
First Notice Day
The first day on which a notice of intent to deliver a commodity to fulfill a short futures contract can be given by the clearinghouse to a buyer (long futures). Sellers can give notice of intent to deliver to the clearing corporation on the day before first notice day. These notices are then processed overnight and passed on first notice day to the oldest longs in the nearby futures month. The first notice day in grain and soybean futures is the last business day of the month before the delivery month (for December corn, the last business day of November).
Signing a forward price contract (usually with your local grain elevator) is the traditional way to set both price and basis before harvest. You and the buyer agree to the price, quantity, quality, and date of delivery. When signed, the forward contract removes the risk of a price decrease or a widening of the basis.
Note: If the market fundamentals change after the contract is signed so that prices move higher, or the basis improves, you are still obligated to deliver at the agreed-to price. Similarly, the loss of your crop (due to hail, for example) does not remove your obligation to make delivery. You might have to buy grain on the open market (perhaps at a higher price) to fulfill the contract. Also known as a flat price contract.
When a futures contract is bought or sold, the price, quantity and quality of a commodity is set now, with the actual acceptance or delivery of the commodity to take place in the future (hence the term futures).
For grains, the standard quantity is 5,000 bushels.
If you sell December corn futures at $3, you are obligated to deliver 5,000 bu. of #2 quality corn in December to an elevator approved by the exchange. You will be paid $3/bu. no matter what the open market price happens to be in December. In practice, producers rarely deliver on a futures contract. Instead, they cancel that contractual obligation by buying the same futures month as the original "sell” order.
Conversely, an order to "buy December futures” at $3 obligates you to purchase wheat in December at a price of $3/bu. no matter what the open market price happens to be. This long contract is normally offset with a "sell December futures” order rather than accepting the wheat at a terminal elevator located in a distant city.
Futures contracts are commonly used by grain producers to price their commodities before the actual cash (spot) sale of the commodity by setting and removing hedges. For grain producers desiring to sell grain, the hedge is "set” by going short the market, and the hedge "removed” by an opposite futures position.
For more information on futures and hedging, visit the Chicago Board of Trade. Contract specifications and many free educational publications are available.
Futures Only Contract
A transaction intended to reduce risk. For a grain producer, to hedge is to price grain through selling futures contracts for the quantity of grain involved, before actually selling it on the cash market. The hedge locks in the futures portion of your price, regardless of what the market does by the time you deliver; the basis is not locked in. Changes in basis levels are generally much less violent than price changes. Hedging is sometimes called "basis merchandising,” since only basis moves will affect the net price received after a hedge is established (set).
Some grain elevators offer hedge-to-arrive cash contracts, in which a "reference” price—equal to the current futures price of the month nearest to when the grain is to be delivered—is established when the contract is signed. The basis portion of the contract is left open. This is in contrast to the forward price contract, in which both basis and price are established at the time the contract is signed. Within the period of the hedge-to-arrive contract, the producer can choose when to "set” the basis.
This is an option with a strike price such that if the option were exercised, you would obtain a futures contract with a "built-in” value. For example, a December wheat put option with a strike price of $3.20, when December wheat futures are $3, is 20¢ in-the-money. Exercising that put would give you a short (sell) December wheat futures contract at $3.20, which you could immediately buy back at the current $3 price for a 20¢ gross profit. Whether you have any net profit depends, of course, on what premium you paid for the put.
A call option would be in-the-money if that option had a strike price lower than the current futures price (e.g., a $1.70 May corn call option would be 20¢ in-the-money if May corn futures were $1.90). The premium of an in-the-money option will be higher than the intrinsic value because time remains during which the price of the corresponding (underlying) futures contract may move to further increase the intrinsic value. The probability of a favorable price move is expressed in the time value of the option. As the option expires, the premium will shrink to the level of that option's intrinsic value.
The intrinsic value of an option is the amount of value available if the owner exercises the option right now. For example, if December corn futures are $2.50 and you own a $2.60 put option—allowing you to enter a short futures position at $2.60—your put would have an intrinsic value of 10¢.
A market in which nearby values are higher than deferred ones. Also known as an inverted market.
A person who is long is one who has bought a futures contract or a call option on the assumption that prices will rise. Such an individual is a "bull,” or "bullish.”
Margin is the earnest money a buyer or seller of a futures contract deposits with the commodities broker. Under the rules of the various commodity exchanges, only members of a given exchange can buy or sell futures contracts. When you place an order to sell 5,000 bushels of December corn with your broker, in reality it is the broker who will own, and be responsible for, that contract. Further, the exchanges require that all futures contracts be "marked-to-the-market” each day, which means simply that the broker must settle all "paper losses” at the close of each business day.
As an example, assume that today you sold 5,000 bushels of December corn at $2 (remember that, in reality, it was the broker who sold, and not you). The next day, assume that corn "settled” at $2.05 – 5¢/bu. above the price where you instructed your broker to sell. As a result, your broker is required to "make settlement” by depositing $250 (5¢ times 5,000 bu.) with the clearinghouse—now. Where does the broker get the $250? From your original margin deposit. In plain words, the margin deposit serves to cover the broker's backside if your market position turns out to be a loser.
The required margin deposit depends on the value of the contract, the volatility of recent price moves, and your financial reputation. Minimum margin requirements are established by the exchanges but may be increased by your broker. As a rough rule-of-thumb, minimum margin requirements are around 10% of the value of the contract. The value of a 5,000-bushel contract of December corn at 200 is $10,000, placing the minimum margin of the contract at around $1,000. If corn futures prices were changing only a fraction of a cent or so for the past few months, the minimum margin would likely fall in the $700-$800 range. Conversely, if December corn futures were experiencing daily price moves of 5¢ to 6¢, the minimum margin would likely be the $1300-$1500 range.
The broker is the real owner of a futures contract (see margin), and daily must cover paper losses by depositing money with the clearinghouse. A continuation of daily losses will soon reduce your margin deposit (earnest money) to the point where the broker might have to deposit his/her money with the clearinghouse to cover additional losses—not what the broker wants to do! When your
original margin deposit is reduced to a pre-established level, the broker will issue a margin call, which simply means the broker wants more money now to cover your—but from the exchange's point of view, the broker's—paper losses.
Using the same "sell December 5,000 bu. corn at $2” example used to explain margin, assume that the futures have risen to $2.10—a paper loss of $500 (10¢/bu. on 5,000 bu.). The broker will now have withdrawn $500 from your initial margin deposit of $1,000, leaving you with a margin balance of $500.
When you originally sold December corn and deposited a margin of $1,000, there was an additional phase in the agreement: "maintain $700.” Since your margin account is now below the minimum level (of $700), the broker asks you to bring that account back to the original margin requirement of $1,000. You must deposit $500 with the broker now. If you don't, the broker will close out your open sell position with a buy order at his/her first opportunity, to remove the possibility that he/she would be required to deposit his/her money with the clearinghouse. Nothing to get upset about—it's strictly business.
Minimum Price Contract
With a minimum price contract, the buyer (typically a grain elevator) uses put options to establish a minimum price for the producer's grain, but will pay the producer a higher price if the futures price rises between the time the contract is signed and the agreed-to-delivery date.
A negative basis implies the futures price is greater than the cash price.
No Price Established
Opportunity cost applies any time you invest cash or could invest cash. In grain marketing, it generally applies to storage. Grain sitting in a bin could be sold and the money invested—either by repaying a loan or by putting the money into an interest-bearing account or stock fund, for example.
Out-of-the-money denotes an option with a strike price that lacks intrinsic value. Assume that March corn is at $1.85. If you owned a March corn put option with a strike price of $1.70, you would have the right to go short (sell) March corn at $1.70. Since March futures are at $1.85, it would not be advisable to exercise that option, since the strike price is 15¢ out-of-the-money
With a call option, out-of-the-money indicates an option with a strike price above the corresponding (underlying) futures contract.
While out-of-the-money options have no intrinsic value, they do have time value, since there is a possibility that between now and when the option expires, futures prices may move to the point where the option becomes in-the-money. As the time between now and when the option expires becomes shorter, the time value of the option decreases, reaching zero on the expiration date.
A positive basis implies the futures price is less than the cash price.
The premium is what you must pay to obtain (buy) an option, or the payment you would receive if you sell an option. The premium is the sum of three different values: the intrinsic value, the time value, and the opportunity cost.
Intrinsic value is the amount that the option is in-the-money. A December call wheat option with a strike price of $2.50 has an intrinsic value of 40¢ if December futures are at $2.90.
The time value is based on the odds that the underlying futures contract will move to a level where the option would have some, or greater, intrinsic value. The odds of a favorable price move are greater the longer the time getween now and when the option expires (i.e., when it can no longer be bought or sold). And the odds of a favorable price move in the underlying futures contract are enhanced if futures prices have been fluctuating over wide levels.
The opportunity cost component of the premium is a minor item, and simply acknowledges that the buyer of an option ties up money in the purchase, which otherwise could be invested in a T-Bill. The interest not earned (foregone) is the opportunity cost. The longer the time between now and when the option expires, the more volatile the price moves of the underlying futures contract; and the higher the opportunity cost, the higher the option premium. At or very near to the expiration time of an option, the option premium will be comprised only of its intrinsic value (if any). This is logical since the futures price now lacks sufficient time to change so that the option can become more valuable, and the opportunity cost (interest) of tying up money in an option premium approaches zero.
If the option lacks intrinsic value (out-of-the-money), then the premium is comprised of time value and opportunity cost. Given a stable futures price, one might hypothesize that the time value and opportunity cost would decrease linearly (i.e., an equal percentage each day) between now and when the option expires. While this may be logical, the premium value experiences its most rapid decreases near the expiration date. To be more specific, premium values decline slowly until about 6 weeks from expiration. During these last weeks, the premium falls rapidly.
This pattern of changes in the premium value has a practical application. A grain producer might have paid 20¢/bu. for an out-of-the-money put to protect against a price decline. If futures prices remain stable, the premium will fall to zero at expiration. Yet, this decline from 20¢/bu. to zero will be concentrated in the last 6 weeks of the option. By selling the put before this time, it would be possible to recover a significant portion of the insurance premium, thereby significantly reducing the cost of insurance. If price protection is still needed, the producer could purchase another put at a later month. This strategy of selling the put before expiration and then buying another put is often termed "rolling forward” the protection. Generally, options should only rarely be held until the expiration date. Selling the option 6 weeks before its expiration generally reduces the cost of this form of price insurance.
As futures prices change, so do the premiums on options. Given December corn at $2.50, a $2.30 put that is 20¢ out-of-the-money might have a premium of 4¢. If December corn futures increase to $2.55, the $2.30 put is now 25¢ out-of-the-money. Yet, the premium might only decrease modestly to 3¢, for example. The reason: As long as time remains, there is a chance that December futures might fall below $2.30, causing the put to gain intrinsic value.
The movement of option premiums relative to the change in futures prices is called the "delta.” Here, December corn changed 5¢, the put premium, 1¢. The delta is 0.2 (1¢ divided by 5¢), denoting that the option premium changed 20% of the futures price. Out-of-the-money puts and calls have delta values less than one. In-the-money puts and calls have delta values near unity.
Assume again that December corn is at $2.50. A $2.60 put would be 10¢ in-the-money, and might have a premium ocst of 14¢ to account for the time value and opportunity cost. If December futures increase to $2.55, the premium of the $2.60 put might fall nearly 5¢ since the option is now only 5¢ in-the-money. With a 5¢ change in both the futures price and option premium, the delta would be 1, denoting that the option premium change was equal to the futures price change.
Owning a put option gives the buyer the right, but not the obligation, to obtain a short (sell) futures position at the option's strike price. The buyer pays the premium price for the option, and has no other obligation unless the option is "exercised.” The broker will normally charge a commission fee of 5% of the premium, or a minimum of $25 but not more than $125, for each option purchased.
Assume that the December corn futures contract is trading at $1.70/bu., and that a December put option with a strike price of $1.50/bu. could be purchased for 5¢/bu. The buyer of this put would pay a premium of $250 and a commission of $25. If corn prices
fell to $1.40 in early November, the put could be sold for perhaps 11¢. Here, the buyer of the put would get about $1.46 for the corn--$1.40 in the open market, plus 6¢ profit from the put (11¢ - 5¢).
Alternatively, the put could be "exercised,” meaning that the buyer could obtain a short futures position (sell) on December corn at $1.50. If the futures contract is obtained, the buyer must deposit the required margin money, and make any required margin calls.
Options expire before the option month (e.g., the December put option on corn would expire in late November).
In grain marketing, rolling forward refers to progressively moving a contract delivery period or price protection from one month out into another, later month. Say, for example, that you own a November soybean put option (which expires in October). In August, you decide you would like to sell that put to recapture part of your premium before the value plummets. You might sell that contract and buy a January put to extend your price protection until you deliver.
A person who is short is one who has sold a futures contract or bought a put option on the assumption that prices will drop. Such an individual is a "bear,” or "bearish.”
Spread is the difference between two futures prices. This might be the price difference between commodities (corn vs. wheat) or between months (March vs. May corn).
The strike price refers to the price at which the option could be exchanged for the corresponding (underlying) futures contract. A $1.90 July corn put option means that the option owner could exchange that option for a short (sell) July corn futures position at $1.90.
Whether or not that would be a wise move depends upon the current price of July corn futures. It would be a wise move if July corn is at $1.60, but not logical if July corn is $2.20.
Strike prices "bracket” the current futures price. If November soybean futures are priced at $5.22, you would see options with strike prices both above and below that price. Options on corn and wheat are established at intervals of 10¢, soybeans, at 25¢. (See at-the-money, in-the-money and out-of-the-money for further details.)
An option's time value is the amount the market builds into the premium to account for the time remaining during which prices might move, potentially making the option more valuable. Also known as extrinsic value.
Volatility is the degree of price change in a market. In options trading, it is broken into past, or historic volatility, and future, or implied volatility.
To write is to sell an option as an initial position. (Note: If you are selling an option to liquidate an existing long position—i.e., selling an option you bought—it is not considered "writing” an option.)
- Summer 2009