Session 1, Lesson 7 / WHAT TO DO WITH AN OPTION / Option Cost
DETERMINING YOUR COST
In previous sessions, we’ve covered some of the basic terminology associated with options. By now you understand that an option is a legally binding contract between two parties who are referred to as the buyer and the seller. There are two different types of options known as puts and calls. We also know that the amount of money that you pay for an option is called premium. We have recently covered the choice of strike prices, and what to do with an option after you have purchased it. We are going to use these basic building blocks of terminology and start to look at how we can incorporate options into our hedging and total marketing program. The first step in that process is determining what our breakeven is on an option position.
When I refer to breakeven throughout this lesson, I am talking about the price necessary to cover both premium and commissions. Breakevens can mean many things to different people. To start our lesson, let’s look at a common strategy of buying a put option to protect a crop from a decline in price. We’ll again use corn as an example, though the concept applies to any of the markets. (Hedging example)
Let’s assume that it is July 5, You contact your broker and decide to buy a December $2.80 corn put which has a premium of 10 cents. Purchasing that option gives you the right, but not the obligation, to be short December corn futures from $2.80. The question now becomes, “what is my cost?” In the case of the put the first thing to do is subtract the premium from the strike price. If you have the right to sell December corn for $2.80, but it costs you 10 cents to do that, your equivalent is $2.70. Is that your breakeven? The answer is no.
We mentioned earlier that your option transactions must take place through a broker. Your broker is going to charge you a fee or commission to handle the contract. For simplicity’s sake, let’s say your broker charges a $50 commission to do an option contract. The $50 commission would amount to 1 cents per bushel on a 5,000 bushel contract. We need to subtract that from the $2.70, and we now have a breakeven of $2.69. What that means is that if by the time the option is ready to expire in November, the difference between the current futures prices and $2.69 would be your approximate profit in the position. Looking at a specific example, let’s now assume that time has rolled ahead to the third Friday in November and December corn futures are now trading at $2.45. At this time you would be able to call your broker and say that you would like to exercise your option.
Your broker would have your option turned into a short futures position at $2.80. Remember – your option turns into a futures position at the strike price and not at the current futures price. Your account would now show a short futures position from $2.80 and you could buy back the futures at the current price of $2.45 which would be a difference of 35 cents per bushel. From that amount, we must now subtract the 10 cent premium that we paid for the option, and the 1 cents in commission. At this point we are left with 24 cents profit from that transaction. There may also be an additional charge from your broker for exercising the option.
Figuring this another way, we mentioned earlier that our breakeven was $2.69. That was determined by taking the $2.80 strike price and subtracting 10 cents premium and 1 cents commission. $2.69 minus the current futures price of $2.45 also gives us 24 cents profit. The 24 cents would then help offset the decline in the futures market. In our example, if we assume that the futures were at $2.80 at the time we purchased our put option and fell to $2.45, there was a 35 cent drop. Assuming there was no change in basis (the difference between the cash price and the futures price), then cash also dropped 35 cents. From our option we have a 24 cent profit to help offset that decline. As you can see, it’s not a perfect hedge because we still had 12 cents that wasn’t covered, but it does get us close.
Now what would have happened if the market would have gone up and we still had bought a put option? Let’s start with the same basic facts of buying a December $2.80 corn put for 10 cents in early July. The current futures price is also $2.80. Come November, let’s say that the price is actually $2.90 on the futures. In that case, our right to sell at $2.80 would not be worth anything. After all, why would we sell for $2.80 when we can sell for $2.90? In this case we would have lost our 10 cent premium plus the 1 cents in commission that we paid. The good news is that the cash market has gone up in that time to offset that expense. Remember that options are like insurance. If your objective is to simply buy options to try to earn a profit trading them, you’re in the wrong part of the business. Options are a risk management tool.
In calculating your breakeven, one final step is to subtract your basis level to determine what cash price you’re actually protecting. In our assignment with this lesson, you’ll have the opportunity to work through some of those examples. In upcoming sessions, we’ll continue to develop the idea of hedge strategies for both buyers and sellers of various products.
ANSWERS TO LESSON 6 ASSIGNMENT
1. If a buyer of an option chooses to sell back the option, he is choosing to do which of the option?-c. Offset / 2. If a trader buys a $56 hog put option and futures are above $60 when the option stops trading, the trader chooses to do nothing with his option. What has the trader decided to do with his option?-a. Have it expire / 3. A trader who originally bought a call option and has his broker convert it into a futures position has done what to that option? – b. Exercise it / 4. Which is the least common outcome for an option contract?-b. Exercise / 5. The buyer of a put option has the right but not the obligation to be short the futures at the strike price. True. / 6. A call option gives the buyer of that option the right but not the obligation to be long the futures from a level equal to the current futures price minus the premium. False. / 7. Jan. soybeans are trading at $5.80, a Jan $6.00 put is trading at 25 cents.- a. time value: 5 cents – b. cash value: 20 cents.
ASSIGNMENT – Please calculate the breakeven levels for the following problems.
Example: Problem 1:
Buy Mar 575 soybean put for $.16 Buy Mar 230 corn put for $.12
Strike price = $5.75 Strike price = ————
– premium = .16 Premium = ————
– commission = .02 – commission = .02
Breakeven = $5.57 Breakeven = ————
Problem 2: Problem 3:
Buy Mar Chi 370 wheat put for $.15 Buy Feb $74 live cattle put for $1.00
Strike price = ————- Strike price = ————
– premium = ————- – premium = ————
– commission = .02 – commission = .25
Breakeven = ————- Breakeven = ————
— The breakeven calculation is critical to determining the profit potential when purchasing an option. — Different strike prices will have different breakevens. Breakeven calculations, therefore, are critical in selecting the appropriate strike price. — As premiums fluctuate, the breakeven will fluctuate also on a day-to-day basis. — Commission costs must be included to accurately calculate breakeven.– Basis levels must still be subtracted from the breakeven to properly determine the cash market hedge that is being established.