Session 1, Lesson 2 / Puts and Calls

WHAT IS AN OPTION?

Since the mid ’80s, Options were been introduced into Commodity futures and traders who used the commodity markets then have been repeatedly barraged with information about options. The commodity exchanges have worked diligently to help inform traders about the availability and potential applications of options for traders.

With all the information that has circulated about options, some traders feel that everyone else must understand them clearly and that somehow they have missed the boat. If you’re not clear on exactly what an option is, you are certainly not alone. This course has been developed because of the widespread questions which still exist, as well as the misunderstandings that exist about options.

In simplest terms, options in general are the legal rights, acquired for a consideration to buy or sell something at a predetermined price by a certain time in the future. Options are very common in real estate, for example Developers will take options on a certain pieces of property as they plan their projects, it gives them time to obtain zoning approvals and raise capital. The option locks in the price and buys time, and the price the developer has paid is the premium, so in other words he pays for the time value.

Those two factors certainly exist with an option. Options are contracts whether we are talking about agricultural products, metals or treasury bonds. The basic concept remains the same for all. The options contract, like most other contracts, involves two parties — in this case what we will call a buyer and a seller. In order for an option contract to exist or to be “traded”, you must have a buyer and a seller. There is a one-to-one relationship here — for every buyer there is a seller and for every seller there is a buyer.

SO WHAT DOES THIS “CONTRACT” INVOLVE? An options contract, like any other contract, conveys certain rights, privileges and obligations. In an options contract, the buyer of the contract acquires or is granted certain privileges or opportunities. They are granted certain rights to take future actions. The seller, on the other hand, is the individual who in turn grants those rights and privileges to the buyer. The seller is taking on an obligation to do something at the choice of the buyer.

At this point the whole arrangement sounds very one-sided in favor of the buyer. The buyer has the right to take a future action but has no obligations, while the seller is obligated to respond based on what the buyer chooses to do. The equalizer in this formula is money. The buyer pays the seller money for giving him this right. The seller, on the other hand, received money from the buyer for accepting the obligation to perform if called upon. In the case of agricultural options, the money which is exchanged is more specifically referred to as premium. In future lessons we’ll be discussing premium in greater detail, but for now understand it to be the money which is exchanged between buyer and seller at the onset of the contract.

To summarize, understand that an option is simply a contract. In every option contract you have two parties — a buyer and a seller. This is always true. The buyer is the one who pays money to receive certain rights, and the seller is the one who receives money for committing to certain obligations. The money is known as premium.

Throughout this course, we’ll be using examples and references to how options are very similar to insurance. With the knowledge we’ve gained so far, we can begin to make that comparison. When you take out an insurance policy, you form a contract. The contract is between yourself and the insurance company. By agreeing to the contract, you acquire for yourself certain rights and privileges, usually the right to collect money in the event of a future loss or disaster. In exchange for that, you pay the insurance company money, or premium.

Your actions are very similar to those of a person buying an option. The insurance company, in forming a contract with you, agrees to be obligated to you and to pay you money in the future in the event of an adverse situation to you. In exchange for accepting this obligation, the insurance company collects or receives from you money or premium. In this example you still have one buyer (yourself) and one seller (the insurance company). Notice also that you may use more than one insurance company, and the insurance company undoubtedly will also have other clients. Your relationship is not exclusive. Options are very similar to this description of how insurance works.

Since insurance and options are so similar, we might find it easier to understand why we would use options if we asked the question “Why do we use insurance?” The reason most people buy insurance is to help them manage their risk. If you are buying car insurance, you buy it to protect yourself from the unexpected loss of a vehicle and from the liability that an accident can entail. If you’re buying health insurance, again you’re buying protection in case of an unexpected illness or other medical expenses that could ruin you financially. The key is that you are not buying the insurance as a profit center, but rather as a risk management tool. This is a most important point when it comes to the use of options as part of a total marketing program. There are traders who speculate and make money on them, we will discuss those issues in advanced stages.

I’ve talked to so many traders who have said they would never use options again because they tried them once or twice and lost money on them. When I hear that, I understand that the person has misunderstood the real function of options as a hedging tool and does not understand total hedging.

EXERCISE: As an example we will look at the price of a corn call and put option as of the close of market activity on Friday, August 25, 1995. We’ll be explaining what puts and calls are, but for now understand that both are option contracts. We will look at the December 280 call and put. These are referred to as strike prices. We will explain what strike prices are in great detail in future lessons. The price of a 280 call is 142 and the price of a 280 put is 64. These quotes are read in grain options just as in the futures quotes, where the last digit is 1/8 of a cent. In this example, we then see that a 280 call is 14 and 1/4 cents per bushel and a 280 put is 6 and 1/2 cents per bushel.

ASSIGNMENT: Based on the following example table, practice writing down premiums for a Mar. 290 corn put, a Mar. 290 corn call, a Dec. 280 corn call and a Dec. 280 corn put. In addition, write down the price for a live cattle Feb. 66 call and an Apr. 64 put. Next record the settlement price for a Feb. 44 hog put and an Apr. 44 call. Finally, write down the price of a feeder cattle Jan. 66 call and a Oct. 64 put. (The table will be displayed in lesson 3.)

Jan. feeder cattle 66 call = $1.05  /  Oct. feeder cattle 64 put = .75 / Feb. live hog 44 put = 1.00

Apr. live hog 44 call = 2.60 / Feb. live cattle 66 call = 1.50 / Apr. live cattle 64 put = 2.00 / Dec. corn 280 call = .10

Dec. corn 280 put = .12 / Mar. corn 290 call = .16 / Mar. corn 290 put = .12

The following items should be considered key points from Lesson 2:

An option is a contract with one buyer and one seller.   A buyer may purchase many options from several different sellers, but each contract has only one seller.  An option seller may sell many different types of options to many different buyers, but each individual contract has only one buyer.  Option contracts have much in common with insurance policies or contracts.  The amount of money paid by the buyer to the seller is referred to as premium.  Options should not be viewed as a stand-alone profit center, but rather are simply a PART of a total trading plan and a vital element in risk management.

In Lesson 3, we’ll look at the specifics of what types of options are available and the difference between puts and calls.