A PRIMER ON UNDERSTANDING FUTURES AND OPTIONS MARKETS IN GRAIN MARKETING
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1 A PRIMER ON UNDERSTANDING FUTURES AND OPTIONS MARKETS IN GRAIN MARKETING An Introduction to Financial and Marketing Tools for WA Wheat Growers Coulee City, Washington February 2, 1999 Larry D. Makus College of Agriculture University of Idaho
2 IMPORTANT TERMINOLOGY 1. Cash Market - a market which focuses on the buying and selling of the physical commodity for immediate or delayed delivery 2. Futures Market - a market which focuses on the buying and selling of futures contracts - a logical extension of a cash forward market - trades a transferable agreement to make or take delivery of a standardized amount and quality of a specified commodity at a specified point in time and location - think of as a market offering a temporary sale of your commodity - can resolve agreements with money rather than delivery
3 FUTURES CONTRACTS 3. Contract Specifications: (see attached) a. Standardized Amount - Contract Quantity = 5000 bu. b. Standardized Quality - Deliverable Grade 1) CBT wheat - USDA #2 soft red winter 2) MPLS white wheat - USDA #1 soft white 3) KC wheat c. Specified Time - USDA #2 hard red winter - Contract Month 1) wheat = Jul,Sep,Dec,Mar,May d. Specified Location - Delivery Point 1) CBT wheat = Chicago or Toledo 2) MPLS white wheat = Lower Columbia
4 4. Margin FUTURES CONTRACTS (Additional Terminology) - money deposited by all traders when entering the futures market to assure performance for all participants - usually a small portion of the total contract value - may receive margin calls if market moves against your position 5. Commission - fee paid to broker for executing a trade in the futures market - based on round-turn or entry and exit of a contract - varies by broker ($30 and up per contract)
5 ALTERNATIVES IN TRADING FUTURES 1. Buy a Futures Contract(s) - long position - have a commitment to receive delivery - can offset commitment at some point 2. Sell a Futures Contract(s) - short position - have a commitment to make delivery - can offset commitment at some point NOTE: entering short or long means you have an obligation (open position) and a margin is required 3. Delivery is an obvious alternative or 4. Offset your open position a. "long" - sell same futures contract at current price b. "short" - buy same futures contract at current price
6 UNDERSTANDING OPTIONS ON FUTURES CONTRACTS 1. Options on futures represent the RIGHT, (but not the obligation) to enter a designated contract at a specific price - main focus is that options give the RIGHT to a futures position, but the option owner is not required to enter a futures position 2. Types of Options a. "put" option represents the right to sell b. "call" option represents the right to buy 3. Strike price is the price at which the option buyer has the right to sell (for a put) or buy (for a call) the underlying contract 4. Option premium is the market value of the right - quoted in cents per bushel (5000 bu.) 5. Option Expiration - expire about the 25th day of month before the underlying futures contract month
7 OPTION EXAMPLES (Focus on Puts) Mid January - Puts on CBT Sep 99 wheat CBT Sep wheat futures price = cents/bu. Strike Price Premium (cents/bu.) Know: 1. can purchase right to sell CBT Sep futures 2. right to sell at several different strike prices above or below the current market price 3. premiums vary by strike price - right to sell is more expensive as strike price goes up 4. option on Sep wheat expires about 25 Aug 99
8 OPTION EXAMPLES (Focus on Puts) CBT Sep wheat futures price = cents/bu. Strike Price Premium (cents/bu.) Option premium influenced by: 1. strike price relative to the current futures price: a. intrinsic value if above futures price put has 0 cents of intrinsic value put has 5 cents of intrinsic value 2. time until expiration: a. futures price can change put can have intrinsic value if futures price goes below 300 b. more time to expiration = more time value c. more market volatility = more time value
9 OPTION EXAMPLES (Focus on Puts) CBT Sep wheat futures price = cents/bu. Strike Price Premium (cents/bu.) Closing a put position: a. sell at the current premium - premium changes over time as futures price changes and expiration approaches b. let option expire if worthless - option expires with no intrinsic value c. exercise and obtain futures position - may be automatic if expires with value
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