G86-771-A
Evaluating Options vs. Futures Contracts
This is number four in a series of six NebGuides on agricultural options. It explains how to
evaluate options vs futures contracts.
Lynn H. Lutgen, Extension Marketing Specialist
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Options vs. Futures Contracts
Different Market Scenarios
Uptrending Market
Downtrending Market
Conclusion
Agricultural Grain Options
Options and futures contracts are similar. Both represent actions that occur in the future. Futures markets
are contracts to either accept or deliver the actual physical commodity, while an option contract is a
contract on the underlying futures contract. Options contracts give the farmer the right, but not the
obligation, to buy or sell an underlying commodity. This underlying commodity is a futures contract. Due
to these similarities and the fact that options are based on a futures contract, producers may question the
value of using an options contract. To make a decision between using a futures contract or an options
contract, producers need to evaluate both alternatives.
Options vs. Futures Contracts
An evaluation investigating advantages and disadvantages of futures and options contracts is necessary.
Advantages of Options
1. No margin calls.
2. Ability to take advantage of favorable price moves.
3. Limited risk. The maximum potential loss is known when the option is purchased.
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Evaluating Options vs. Futures Contracts, G86-771-A http://www.ianr.unl.edu/PUBS/farmmgt/g771.htm
Disadvantages of Options
1. Must pay a premium.
2. Because of the "price insurance" (premium) associated with options, they may yield a lesser return
than other marketing alternatives in certain market situations.
3. If an option is exercised, a futures position, with all its financial and contract obligations, is
assumed.
4. Option premiums may not move penny for penny with futures contract moves "Delta" effect.
Advantages of Futures Contracts
1. If price moves are favorable, the producer realizes the greatest return with this marketing
alternative.
2. No premium charge is associated with futures market contracts.
Disadvantages of Futures Contracts
1. Subject to margin calls.
2. Unable to take advantage of favorable price moves.
3. Net price is subject to Basis change.
To make a true comparison between a futures contract and an options contract, the producer should set
up potential price scenarios based on his outlook of future market trends.
Different Market Scenarios
Uptrending Market
Market Situation: Suppose, after spring planting, a farmer decides to use a forward pricing technique to
market a portion of his corn crop. Due to wet, cold weather in Russia, plantings have been severely
delayed with some speculation that planted acreage is down 10% from year ago levels. In addition, the
value of the U.S. dollar has eased over the winter months with hope that buying patterns will shift
favorably toward U.S. agricultural products.
Although the farmer has a bullish market outlook, we would like to lock in a set price for corn. Let's take
a look at a hedging strategy and then an options strategy.
Alternative 1: Hedging. On May 31, the December corn futures were trading at $2.50. Although the
farmer feels prices may move higher than $2.50, a hedge is placed to guard against the risk of a price
decrease. The local spot price is $2.30. On December 1, the farmer closes the futures position by buying
back the December contract which is now trading at $2.65. Grain is delivered to the local elevator where
the spot price is $2.42. The farmer's transactions and returns:
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Evaluating Options vs. Futures Contracts, G86-771-A http://www.ianr.unl.edu/PUBS/farmmgt/g771.htm
Hedging Price Increase
10,000 bu #2 yellow corn
May 15 December Corn S 2.50
Dec 1 B 2.65
--Futures Profit or (Loss) (-.15)
Dec 1 Spot Price 2.42
--Futures Profit or (Loss) (-.15)
-----Net Return 2.27
Before contrasting this with an options contract, let's look at the advantages and disadvantages of this
marketing decision.
Advantages: Even though prices trended against the producer's position, an assured price for the corn
crop was secured. Loss in the futures market was nearly completely offset by the gain made in the local
spot market. (2.42 - 2.30 = $.12 gain in spot market vs. -.15 loss in the futures market.)
Disadvantages: Due to the nature of a futures contract position, the producer was unable to take
advantage of any price increases. As prices traded above the 2.50 contract position, margin calls also had
to be met.
Alternative 2: Options Contract. Suppose an options contract was used instead. On May 15 these were
the strike prices and premium values for a December corn put option.
Strike Price ($/bu) Premium (1/8 /bu)
$2.30 1/4
2.40 5/8
2.50 4
2.60 11 5/8
2.70 21 3/4
The producer bought the 2.50 put option for a four cent premium expense. With futures prices trading at
2.65 on December 1, the producer allowed his put option contract to expire.
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Options - Price Increase
May 15 Put Option December Corn
--Strike Price 2.50
--Premium .04
Dec 1 Futures December Corn 2.65
--Spot Price 2.42
Actions: Allows contract to expire and sells corn locally.
--Spot Price 2.42
--Less Premium -.04
----Net Price 2.38
Advantages: Buying a $2.50 put option in May yields a net price of $2.38 when December futures are
$2.65 at harvest. Futures prices rose above the $2.50 strike price, and the farmer chose to let the option
contract expire. This strategy allows the producer to take advantage of the higher local cash price
without having an offsetting loss of $.15 cents in the futures market. The farmer was also not subject to
margin calls when futures prices rose above his $2.50 strike price.
Disadvantages: The producer paid four cents premium on May 15 which must be deducted from the
receipts of the local cash sale.
Summary - Price Increase. In an uptrending market, an options contract is most profitable. In the
example, the option alternative yielded $2.38/bu, while the futures alternative returned $2.27/bu. The
difference in net return between the two alternatives ($2.38 - $2.27 = $.11) is associated with the $.15
loss on the futures contract in the hedging alternative less the four cent premium expense associated with
the option contract ($.15 - $.04 = $.11).
When considering the futures contract, it may be argued that any price increase would be offset by an
equal gain in the cash market. Although there would generally be a price increase in the local market, it
may or may not equal the price increase in the futures market. In comparing futures and options
contracts, the options contract would generally remain more profitable than the futures contract
alternative regardless of the associated price increase in the cash market. As long as the premium value is
less than the loss on the futures contract, the option contract alternative would be most profitable in an
uptrending market.
Downtrending Market
Market Situation: Suppose carryover stocks from the previous crop year continue to overshadow and
depress prices. The prospects for increased export earnings look dim in light of a stable U.S. currency
and excellent spring planting conditions. The farmer's outlook on the industry is bearish. He decides to
lock in a price for his crop, but first he examines both pricing alternatives.
Alternative 1: Hedging. Suppose on May 15 the December corn futures are trading at $2.40/bu. The
current bid price at the local elevator is $2.20/bu. Fearing lower prices, the farmer hedges corn. On
December 1, the producer closes the future contract position by buying back the December contract
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Evaluating Options vs. Futures Contracts, G86-771-A http://www.ianr.unl.edu/PUBS/farmmgt/g771.htm
which is now trading at $2.20/bu. Upon delivery of the grain to the local market, the producer receives a
spot price of $2.00/bu.
Advantages: The producer secured an assured price for corn on the futures market. Because prices
traded in the producers favor, no margin calls were made. In addition, no premium values are associated
with futures contracts. In a downtrending market, this alternative realizes a higher return than an options
contract would because of an options associated premium expense.
Disadvantages: Although prices moved favorably, there is always the risk of adverse price moves in
relation to a futures position. This risk could result in margin calls and losses on the futures market.
Hedging - Price Increases
--10,000 bu #2 yellow corn
May 15 December corn S 2.40
Dec 1 December corn B 2.20
--Futures Profit or (Loss) +.20
Dec 1 Spot Price 2.00
--Futures Profit or (Loss) +.20
$2.20
Alternative 2: Options Contract. Suppose the farmer established an options contract in a downtrending
market. On May 15, these option strike prices and premiums were reported.
Strike Price ($/bu) Premium (1/8 /bu)
$220 1
230 3 1/2
240 12
250 17 1/2
260 21 3/4
The farmer decides to purchase the $2.40/bu put option which has an associated premium of 12 cents.
With futures prices trading at $2.20/bu on December 1, the farmer exercises this contract. By doing so,
the farmer assumes a short position at $2.40 on the December corn futures contract. The farmer would
immediately offset this position by purchasing a December corn futures contract at the current $2.20.
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Evaluating Options vs. Futures Contracts, G86-771-A http://www.ianr.unl.edu/PUBS/farmmgt/g771.htm
Option Price Decreases
May 15 Put Option December Corn
---Strike Price 2.40
---Premium .12
Dec 1 Futures December Corn 2.20
---Spot Price 2.00
Actions: Exercises options contract and offsets futures position.
Dec 1 December Corn S 2.40
Dec 1 December Corn B 2.20
---Futures Profit or (Loss) +.20
Dec 1 Spot Price 2.00
---Futures Profit or (Loss) +.20
---------Net Return (Spot ± Futures) 2.20
---Less Premium -.12
---Net Return with Options 2.08
Readers should note in this example the premium used was 12 cent vs the previous example using a 4 cent premium. This was
done to illustrate that in the first example the market philosophy was for prices to rise (little or no risk to the seller) therefore low
premium. Second example, more risk that the option would be exercised, higher premium.
Advantages: In this situation the farmer took advantage of the 12 cent insurance plan. When prices
moved below the 2.40 strike price, the farmer exercised this option. In this way, the farmer profited on
the futures market by 20 cents. With this position, the farmer was still free to take advantage of any price
increases had they occurred.
Disadvantages: Although the producer profited by 20 cents on the futures market, the actual return was
whittled down after premium expense was deducted.
Summary - Price Decrease. The hedging alternative would have been most profitable in this example of
a downtrending market. The hedging alternative yielded $2.20/bu while the option alternative yielded
only $2.08/bu. The difference in net returns (2.20 - 2.08 = .12) is due solely to the premium associated
with the option contract.
Conclusion
Options and futures contracts are forward pricing mechanisms that can be used by producers to establish
an assured price level. Determining market trends is mere speculation. However, there are tools available
to help the producer make an educated, sound, market analysis.
Futures and options contracts were each compared in both uptrending and downtrending market
situation.
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In a downtrending market, using a futures contract yielded the highest return. As long as prices continued
to drop, the returns on the futures market were pure profit. Because there are no premium values
associated with futures contracts, no premium was deducted from the profit.
If an options contract was used, the premium value had to be deducted from returns, thereby making it
less profitable than the futures contracts.
In the case of an uptrending market, an options contract is generally more profitable than a futures
contract. In an uptrending market, a futures contract loses money on the futures market and margin calls
must be met. When options are used, no margin calls are made and the producer can allow his option
contract to expire to take advantage of the price increase in the local market. An options contract would
yield a higher return as long as the premium is less than the loss associated with the use of a futures
contract on the futures market.
AGRICULTURAL GRAIN OPTIONS
This series includes the following NebGuides which may be obtained at your local Cooperative Extension
office.
G85-768, Basic Terminology for Understanding Grain Options
G85-769, Options Contract Specifications on grain FuturesContracts
G85-770, An Introduction to Grain Options on Futures Contracts
G85-771, Evaluating Grain Options Versus Futures Contracts
G85-772, Using Grain Options to Follow a Rising Market
G85-773, How to Evaluate Grain Pricing Opportunities
File G771 under: FARM MANAGEMENT
K-21, Futures Trading
Issued November 1986; 6,000 printed.
Electronic version issued April 1997
pubs@unlvm.unl.edu
Issued in furtherance of Cooperative Extension work, Acts of May 8 and June 30, 1914, in cooperation
with the U.S. Department of Agriculture. Kenneth R. Bolen, Director of Cooperative Extension,
University of Nebraska, Institute of Agriculture and Natural Resources.
University of Nebraska Cooperative Extension educational programs abide with the non-discrimination
policies of the University of Nebraska-Lincoln and the United States Department of Agriculture.
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Evaluating Options vs. Futures Contracts, G86-771-A http://www.ianr.unl.edu/PUBS/farmmgt/g771.htm
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