Have you ever come across a word that means something different to almost everyone that you might ask to define it? Have you ever tried to get a definitive answer to a question that doesn’t have just one?
If I were to ask you what an option is, what would be your answer? Some might call it a type of football offense. Others may respond that it is simply an alternative choice. While those are technically correct, the definition that I am looking for has more of a financial element to it. You have likely already guessed that we are talking about puts and calls … the kind of options dealt with in most marketplaces.
So again, I ask, what is an option? Some may respond with the two types (put or call). More might refer to it as a kind of price insurance. Some might call them a marketing instrument. Others still may shrug their shoulders and simply say, “I don’t know.”
Again, what they are and what they do can be described by many different people in many different ways … and they would all be right. However, for the sake of creating some uniform understanding (and for the sake of keeping my promise in a previous issue), we are going to talk about options (puts and calls) for what they are and what they mean to dairymen as they manage risk around their operating margins.
Options 101
Let’s first answer our initial question … what an option (on commodity futures) is. Simply stated, an option is the right – but not the obligation – to buy or sell something at a specific predetermined price (strike price) at any time within a specified time period. To distinguish the difference between the right to buy or sell, there are two types of options that exist: puts and calls.
A call option grants the right to buy futures contracts, while the put option grants the right to sell futures contracts. It is important to understand that one is not the opposite of the other. Every call has a buyer and a seller. Every put has a buyer and seller.
You cannot use one to offset (eliminate from current holdings) a position in the other. In other words, if you buy a put, you must sell the exact same put to exit that position. With regard to buying and selling, buyers of calls or puts are purchasing the rights offered by each option. The seller of the call or put options is selling (granting) the rights extended by each option.
In order to make the transaction between buyers and sellers functional, and in an effort to define the value of the rights that are being bought or sold, options are traded for a price known as premium. Premium is exchanged at the time of the transaction. The buyer pays the premium in exchange for the rights we discussed. The seller receives the premium and is obligated to fulfill the rights now owned by the buyer.
Once the premium is paid, the buyer has limited loss potential (premium paid) and unlimited gain potential (exception given to puts, since the value of a commodity cannot go below zero). The seller on the other hand has limited gain potential (premium received) and unlimited loss potential due to the obligations required to fulfill the buyer’s rights.
If you think about the way all of this comes together, the arrangement is very much like any insurance contract you may already have and be familiar with.
The buyer of the insurance has an interest in reducing the risk/exposure they may have on a given asset, so they pay a premium to a company willing to assume the risk/exposure the insurance buyer is looking to reduce/eliminate. The insurance company accepts the premium under the understanding that it will make the “insured” whole in the event of a claim.
So in this exchange/transfer of risk between a buyer and seller, how do they arrive at what that exchange is worth? How are premium values established? Much like any other market, the forces of supply and demand are alive and well in this process. Options are traded in the same “auction” environment that the commodity futures they represent are traded. Buyers want to pay the least they can, while sellers seek the most premium they can.
However, in the process of coming to a final price, there are a few basic variables that impact an option’s value. First is the distance that the option is from the current value of the underlying commodity.
For example, if the price of corn is $4 per bushel and the buyer and seller are pricing a call (the right to buy futures) option that is at $4 per bushel, the premium will be greater than if they are pricing a call option that is at $4.50 per bushel. This is very similar to pricing insurance that has a zero “deductible” versus pricing insurance with a mid-level deductible.
The second element is the amount of time the option will be covering. Very similar to insurance, if the length of the policy is for one month, the premium is less than if the coverage would extend for one year.
The more time that is being sought, the more you should expect to pay for the option. Last, the volatility of the market will also play a role in the value of the option. Again, using insurance as a proxy for our understanding, think about buying insurance on a building.
If your agent pulls in the driveway and the skies are clear, the birds are singing, and all is well, the quote on the insurance for your building will be far less than if he pulls in and there is smoke rolling out the roof and there is a hailstorm heading for your location. If a claim is much more imminent, costs will be higher.
While the insurance company may be obligated to make the insured whole in the event of a claim, they are not generally interested in owning the underlying asset. To assure that the insured is not reckless or careless in the handling of the asset, they will either use a deductible or elevated premium to keep the insured honest.
Much in the same way, an option is not an efficient tool for the transfer of ownership of the underlying commodity. There are far better ways to buy feed or sell milk.
The simple addition of the added premium cost makes it much more difficult to compare the immediate pricing advantage available if one were to buy feed or sell milk on the very same day an option would be purchased. So why would one ever take such an action?
Reality is such that very few producers are willing to buy 100 percent of their feed needs or sell 100 percent of their milk production all in one moment. Typically, those decisions are spread out over time and involve a number of different transactions. However, while all of those decisions are being made, different risks are still present in the market.
Moreover, while that risk may be fully understood, producers often recognize that market opportunities could improve from today to some other future date. Options provide coverage against ever-present market risk while affording the buyer of the option the ability to wait out better opportunities or wait until further knowledge about different variables is better known.
Options provide better clarity to future results by transferring risk to another party in exchange for more definitive pricing. In our next article, we will spend time looking at specific instances where options can be used and how the options perform to provide you with the coverage you seek.
In the meantime, understand that a tool exists to give you the options and flexibility that your business requires during these most uncertain times. PD
For nearly 20 years, Mike North has educated and guided dairymen and farmers in their efforts to manage commodity price risk.
Mike North
President
Commodity Risk Management Group
