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Options Trading in Agriculture Commodities

May 04
03:44 2011

The mechanism of options trading is exactly the same in agriculture commodity futures markets as it is in any other market, so if you are already familiar with trading options in single stocks or stock index futures, for instance, you will know how options work in agriculture commodity markets. However, if you aren’t familiar with options trading, it’s important to know how it works.

There are two types of options: puts and calls. One who buys  a put has the right – but not the obligation – to sell the put’s underlying security at a certain price until the put expires. One who owns a call has the right – but not the obligation – to buy its underlying security (at a price, before expiration). The language about having “the right but not the obligation” is why these instruments are called options, after all, and it’s why they can be so desirable. Option owners end up taking a short or long position in the underlying market if and only if the market moves in a direction that is profitable to them.

On the other side of any option is someone who sold the put or call and received a “premium” from the buyer. The option seller will get to keep that premium if the market never moves past the option’s strike price, but he will experience a loss if the market moves “in-the-money.” An option may be one of three things:

out-of-the-money: A put is out-of-the-money if the underlying security is currently priced higher than the put’s strike price. A call is out-of-the-money if the underlying security is priced lower than the call’s strike price. So any out-of-the-money option conveys no intrinsic benefit to its owner.

at-the-money: If the underlying security is currently priced at exactly the strike price, the options are called at-the-money. However, you can imagine how vanishingly small are the chances of that happening, and at-the-money options are rarely exercised.

in-the-money: A put is in-the-money if the underlying security is currently priced lower than the put’s strike price.  A call is in-the-money if the underlying security is priced higher than the call’s strike price. This is when the option’s buyer benefits because there is profit in buying and selling the underlying security at these price differences. Also, it’s when the option’s seller is responsible for that loss.

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So you can see how options trading has fit in well with the underlying purpose of agriculture commodity futures markets – to provide a marketplace for producers and end users to efficiently transfer risk. A farmer is the ideal buyer of a put in the grain futures market, for instance. If the market moves higher, he will still be able to sell his grain at a higher price without taking a loss in the futures market. But if the market moves lower, he has effectively established a floor price for his grain. The agriculture commodity markets are also ideal places for speculators to become involved in writing options, or using options to hedge their own long or short futures positions beyond a certain price movement.

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