Buying Wheat Call Options to Profit from a Rise in Wheat Prices

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Contents

Buying Wheat Call Options to Profit from a Rise in Wheat Prices

If you are bullish on wheat, you can profit from a rise in wheat price by buying (going long) wheat call options.

Example: Long Wheat Call Option

You observed that the near-month Euronext Milling Wheat futures contract is trading at the price of EUR 146.50 per tonne. A Euronext Wheat call option with the same expiration month and a nearby strike price of EUR 150.00 is being priced at EUR 9.7700/ton. Since each underlying Euronext Milling Wheat futures contract represents 50 tonnes of wheat, the premium you need to pay to own the call option is EUR 488.50.

Assuming that by option expiration day, the price of the underlying wheat futures has risen by 15% and is now trading at EUR 168.50 per tonne. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying wheat futures at the strike price of EUR 150.00. This means that you get to buy the underlying wheat at only EUR 150.00/ton on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying wheat futures at the market price of EUR 168.48 per tonne, resulting in a gain of EUR 18.50/ton. Since each Euronext Milling Wheat call option covers 50 tonnes of wheat, gain from the long call position is EUR 925.00. Deducting the initial premium of EUR 488.50 you paid to buy the call option, your net profit from the long call strategy will come to EUR 436.50.

Long Wheat Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (EUR 168.50/ton – EUR 150.00/ton) x 50 ton
= EUR 925.00
Investment = Initial Premium Paid
= EUR 488.50
Net Profit = Gain from Option Exercise – Investment
= EUR 925.00 – EUR 488.50
= EUR 436.50
Return on Investment = 89%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the wheat option sale will be equal to it’s intrinsic value.

Learn More About Wheat Futures & Options Trading

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Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

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Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying (Going Long) Wheat Futures to Profit from a Rise in Wheat Prices

If you are bullish on wheat, you can profit from a rise in wheat price by taking up a long position in the wheat futures market. You can do so by buying (going long) one or more wheat futures contracts at a futures exchange.

Example: Long Wheat Futures Trade

You decide to go long one near-month CBOT Wheat Futures contract at the price of USD 5.7000 per bushel. Since each CBOT Wheat Futures contract represents 5000 bushels of wheat, the value of the futures contract is USD 28,500. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 3,375 to open the long futures position.

Assuming that a week later, the price of wheat rises and correspondingly, the price of wheat futures jumps to USD 6.2700 per bushel. Each contract is now worth USD 31,350. So by selling your futures contract now, you can exit your long position in wheat futures with a profit of USD 2,850.

Long Wheat Futures Strategy: Buy LOW, Sell HIGH
BUY 5000 bushels of wheat at USD 5.7000/bu USD 28,500
SELL 5000 bushels of wheat at USD 6.2700/bu USD 31,350
Profit USD 2,850
Investment (Initial Margin) USD 3,375
Return on Investment 84.4444%

Margin Requirements & Leverage

In the examples shown above, although wheat prices have moved by only 10%, the ROI generated is 84.4444%. This leverage is made possible by the relatively low margin (approximately 11.8421%) required to control a large amount of wheat represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

Learn More About Wheat Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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Grain Price Options Basics

File A2-66
Updated December, 2009

The basic concepts of grain price options are discussed below. Methods of using grain price options to market grain are presented in:

An option is the right, but not the obligation, to buy or sell a futures contract. The buyer of an option acquires this right. The option seller (writer) must take the opposite side of the option buyer’s futures position. For example, if you buy an option with the right to buy futures, the option seller (writer) must sell futures to you if you exercise the option. Option contracts are traded in a similar manner as their underlying futures contracts. All buying and selling occurs by open outcry of competitive bids and offers in the trading pit.

Types of Options

If you buy an option to buy futures, you own a call option. If you buy an option to sell futures, you own a put option. Call and put options are separate and distinct options. Calls and puts are not opposite sides of the same transaction.

Strike Price

When buying or selling an option, you must choose from a set of predetermined price levels at which you will enter the futures market if the option is exercised. These are called strike prices. For example, if you choose a soybean option with a strike price of $7 per bushel, upon exercising the option you will buy or sell futures for $7. This will occur regardless of the current level of futures price.

Strike prices are listed at predetermined price levels for each commodity: every 25 cents for soybeans, and 10 cents for corn.

When trading is initiated on an option, trading is available at a series of strike prices above and below the current future’s price. For example, if the July corn futures price is $3, there will be corn options introduced with strike prices of $2.80, $2.90, $3.00, $3.10, and $3.20. If futures price increases (decreases), additional strike prices are added.

Delivery Month

When buying an option you must choose which delivery month you want. Options have the same delivery months as the underlying futures contracts. For example, corn options have December, March, May, July, and September delivery months, the same as corn futures. If you exercise a December corn op­tion you will buy or sell December futures.

Closing-out your Option

There are three ways you can close out an option position. The option can be exercised, it can be sold, or the option can be allowed to expire.

Exercise
Exercising an option converts the option into a futures position at the strike price. Only the option buyer can exercise an option. When a call option is exercised, the option buyer buys futures at the strike price. The option writer (seller) takes the opposite side (sell) of the futures position at the strike price. When a put option is exercised, the option buyer sells futures at the strike price. The option writer (seller) takes the opposite side (buy) of the futures position.

Because of the option seller’s obligation to take a fu­tures position if the option is exercised, he/she must post margin money and is faced with the possibility of margin calls.

Offsetting Transaction
If you have already purchased an option, you can offset this position by selling another option with the same strike price and delivery month. You are now out of the options market. The amount of gain or loss from the transaction depends on the premium you paid when you purchased the option and the premi­um you received when you sold the option, less the transaction cost.

However, if the option you sell does not have the same strike price and/or delivery month as the option you originally purchased, you will now have two positions in the market; one as a buyer and another as a seller.

If you have written (sell) an option, you can offset this position by buying an option with the same strike price and delivery month. You are now out of the options market. The amount of gain or loss from the transaction depends on the premium you received when you sold the option and the premium you paid when you repurchased the option, less the transaction cost. However, you run the risk of having the option exercised by the buyer before you offset it.

Expire
An option expires if it is not exercised within the time period allowed. The expiration date is the last day on which the option can be exercised. Options expire in the month prior to contract delivery. For example, a July corn option expires in June.

Call Options

An option to buy a futures contract is a call option. The buyer of a call option purchases the right to buy futures. The seller (writer) of the call option must sell futures (take the opposite side of the futures transaction) if the buyer exercises the option. For the right to exercise the option, the buyer pays the seller a premium.

The buyer of a call option will make money if the futures price rises above the strike price. If the rise is more than the cost of the premium and transaction, the buyer has a net gain.

The seller of a call option loses money if the futures price rises above the strike price. If the rise is more than the income from the premium less the cost of the transaction, the seller has a net loss.

If the futures price drops below the strike price, the option buyer will not exercise the option because exercising will create a loss for the buyer. In this situation the option buyer will let the option expire worthless on the expiration day. The only money transfer will be the premium the option buyer originally paid to the writer.

Put Options

An option to sell a futures contract is a put option. The buyer of a put option purchases the right to sell futures. The writer (seller) of the put option must buy futures (take the opposite side of the futures transaction) if the buyer exercises the option. For the right to exercise the option, the buyer pays the seller a premium.

The buyer of a put option will make money if the futures price falls below the strike price. If the decline is more than the cost of the premium and transaction, the buyer has a net gain.

The seller of a call option loses money if the futures price falls below the strike price. If the decline is more than the income from the premium less the cost of the transaction, the seller has a net loss.

If the futures price rises above the strike price, the option buyer will not exercise the option because exercising will create a loss for the buyer. In this situation, the option buyer will let the option expire worthless on the expiration day. The only money transfer will be the premium the option buyer originally paid to the seller.

Premium

As discussed previously, the amount paid for an option is the premium. The option buyer pays the premium to the option writer (seller) at the time of the option transaction. The premium is the only part of the option contract that is negotiated. All other contract terms are predetermined. The premium is the maximum amount the option buyer can lose and the maximum amount the option seller can make.

An option premium is composed of intrinsic and/or extrinsic value.

Intrinsic Value
The intrinsic value is the amount of gain that can be realized if the option is exercised and the resulting futures position closed out. A call option has in­trinsic (exercise) value if the futures price is above the strike price. A put option has intrinsic (exercise) value if the future price is below the strike price.

Extrinsic Value
Extrinsic (extra) value is the amount by which the option premium exceeds the intrinsic (exercise) value. Extrinsic value is the return that option writers (sellers) demand in return for bearing the risk of loss from an adverse price movement. All option premiums contain extrinsic value except at expi­ration. Because of extrinsic value, an option buyer can sell an option for as much or more than its exercise value.

The amount of extrinsic value is influenced by three factors:

  • Time value – Time value is based on the length of time before the option expires. If the expi­ration date is far-off, time value will be high. As expiration approaches, the time value de­clines. At expiration, no time value remains.
  • Future price vs. strike price – The relationship of the futures price to the strike price affects the extrinsic value. The extrinsic value is highest when the futures price is the same as the strike price. The extrinsic value declines as the fu­tures price moves away (above or below) from the strike price.
  • Market volatility – As the futures market becomes more volatile, the extrinsic value increases.

Other Option Terms

Additional commonly used option terms are discussed below. These option terms pertain to the relationship between the current futures price and the strike price.

In-the-money
An option is in-the-money if it has exercise value. In other words, a call option is in-the-money if the current futures price is above the strike price be­cause it can be exercised at the strike price and sold at the current futures price for a gain. A put option is in-the-money if the current futures price is below the strike price.

Out-of-the-money
An out-of-the-money option has no exercise value. A call option is out-of-the-money if the current futures price is below the strike price. Conversely, a put option is out-of-the-money if the current futures price is above the strike price.

At-the-money
An option is at-the-money if the current futures price is the same as the strike price. A one cent change in the future price will put the option either in-the-money or out-of-the-money.

Below are examples of call and put options that are in-the-money, at-the-money, and out-of-the-money.

Premium Examples

Below are actual examples of soybean option premiums for various strike prices and delivery months. The premium for each strike price and delivery month is listed. In parentheses are the intrinsic (exercise) value and the extrinsic value for each op­tion premium. The current futures prices are at the bottom of the table.

Soybean Call Options – March 1

Soybean call option premiums on March 1 are shown in Table 1. The current futures price for the July and August futures contracts is $6.50. At this price the $6 strike price option is in-the-money by 50 cents. If this option is exercised, the option buyer will own a futures contract purchased at a strike price of $6. The option buyer can then sell the contract at the current $6.50 futures price for a gain of 50 cents ($6.50 – 6.00 = $.50). The $6.00 strike price option has extrinsic value of 8 cents, the difference between the premium and the exercise value.

The $7 strike price July option has a premium of 14 cents. It has no intrinsic value because it is out-of-the-money by 50 cents. Futures price would have to rise by over 50 cents before the option would contain any exercise value. Its extrinsic value is 14 cents.

The $6.50 strike price July option is at-the-money. It has no intrinsic value but has extrinsic value of 29 cents.

The options with strike prices at-the-money and out of-the-money have premiums containing no intrinsic value (exercise value.) Only those options that are in-the-money have premiums with intrinsic value.

Time value
The August options have higher extrinsic values than the July options. For example, the July $6.50 strike price option has extrinsic value of 29 cents while the August $6.50 option’s extrinsic value is 37 cents.

This occurs because the August option will be traded for a longer period of time than the July option. The time period from March 1 to mid July, when the August option expires, is four and one-half months. The time period from March 1 to mid June for the July option is only three and one-half months.

Call option writers (sellers) bear the risk of loss due to a price rise. They demand a higher return (premium) for bearing this risk for a longer time period, especially considering that June and July are usually periods of price volatility due to the crop growing season.

Strike Price vs. Futures Price
The extrinsic value is 29 cents for the at-the-money July $6.50 strike price option. It is only 14 cents for the 50 cents out of-the-money option ($7 strike price option) and 8 cents for the 50 cents in-the-money option ($6 strike price option). So the extrinsic value decreases as the option moves further out-of-the-money or in-the-money.

An option trader who is writing a call option for $6.50 will be liable for exercise value if the futures price increases by only one cent. However, by writing a $7 option, the futures price will have to rise by over 50 cents before the writer will be liable for exercise value. So the writer will demand a higher return (extrinsic value) for writing an at-the-money option.

Soybean Put Options – March 1

Soybean put option premiums are shown in Table 2. The strike prices and delivery months are the same as Table 1. The date on which the option quotes were taken (March 1) and the futures prices ($6.50) are also the same.

The premium relationships are similar to those of the call options of Table 1. However, the put option premiums with strike prices above the futures price contain intrinsic value while those below contain no intrinsic value. This relationship is opposite to that of the call options in Table 1. This occurs because exercising a put option places the option buyer in the futures markets selling (rather than buying) futures at the strike price. The futures position can then be offset by buying a futures contract at the lower price for a gain.

Soybean Call Options – June 1

Soybean call option premiums on June 1 are shown in Table 3. Futures prices have risen from $6.50 to $8.25 during the three month period.

The March 1 $6.50 strike price at-the-money August call option is now worth $1.84. The premium contains intrinsic (exercise) value of $1.75 ($8.25 – 6.50 = $1.75) plus 9 cents of extrinsic value ($1.84 – 1.75 = $.09). If you had purchased a $6.50 strike price August call option for 35 cents on March 1, you could now sell it for $1.84 for a gain of $1.49 ($1.84 -.35 = $1.49) not including trading costs. The at-the-money option is now the one with the $8.25 strike price, rather than the $6.50 strike price.

Market Volatility
The extrinsic value is greater on June 1 than it was on March 1. For example, the extrinsic value for the August at-the-money ($8.25 strike price) option is 44 cents rather than 35 cents that the at-the-money ($6.50 strike price) option was on March 1, even though the time value is three months less (1 and a half months to expiration vs. 4 and a half months). This is because the market is much more volatile on June 1 than it was on March 1. Because of market volatility, option writers demand a higher return to compensate them for the greater risk of loss due to a rapidly changing market.

Don Hofstrand , retired extension value added agriculture specialist, [email protected]

Ag Decision Maker, Iowa State University Extension and Outreach, Department of Economics, [email protected], 641-732-5574

Copyright © Iowa State University Extension. All rights reserved. | Policies | State & National Extension Partners | Text Only |

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