One of the most frequently asked questions I get on Farm Girl Next Door is, “How do I use futures & options?”
Let’s start by talking Pelotons, because who hasn’t been talking about Peloton bikes and home gyms this year…
What if back in January, someone bought an option for $50 that gave them the opportunity to buy a Peloton at $1,000? The option expires at the end of the year. At that time, they won’t have to buy the Peloton, but they will have the opportunity to. If they decide not to buy the bike, they’ll simply lose the $50 they paid for the option.
Today, the price of a Peloton is $2,000. If they choose to exercise their right, they’ll pay $1,000 for the bike (or $1,050 total with the cost of the option included, which is $950 less than the current list price).
Or, they could sell this option to buy the Peloton for $1,000 to someone else. If I were going to buy a Peloton, I can tell you I’d be willing to pay more than $50 to that option holder to have the ability to buy the Peloton for $1,000 instead of $2,000. While I’m not willing to pay them $1,000 (the value of the increase in the bike price) for the option, I’d still be willing to pay more than $50. Thus, the value of their option increased, just not penny for penny with the increase in the price of the Peloton.
Enough about the Peloton and me wishing it were cheaper… 🙂
Let’s talk about how you could buy a call option to capitalize on increases in futures prices.
A call option = the right, but not the obligation, to buy a commodity at a specified price.
You don’t have to exercise this option to buy the commodity on the underlying futures contract, but when you buy a call, you get the opportunity to exercise this right if you desire to do so.
If the market rallies, the bought call becomes more valuable.
You won’t capture the value penny for penny as the market moves like you would if you bought futures, but it will increase in value as the futures price appreciates.
Furthermore, your downside risk is limited to the premium you paid to purchase the option. Compared to buying a futures contract, buying a call is less risky. With a futures position, you would lose penny for penny if the market falls.
Example Scenario:
You sold soybeans at harvest but have been listening to the bullish sentiment in the market. You already sold, but you want a way to take part in the market and capitalize on futures price appreciation. However, you’re not willing to buy a futures contract outright and risk your position losing value penny for penny if the market falls.
So, you decide to buy a call because it will gain value if the market moves up, but you’ll only lose the initial cost of the option if the market falls and the call expires worthless.
12/1/2020:
The March soybean futures price is currently trading at $11.63. You buy one March soybean (SH21) call option (5,000 bushels) with a strike price of $12.00.
The cost to buy this call option is $0.30/bu.
12/21/2020
The market has been moving up since December 1st. It’s now December 21st, and SH21 is trading at $12.44.
The $12.00 SH21 call option is now worth around $0.70/bu.
Thus, if you decide to sell the option today, you would capture $0.40/bushel ($0.70 – $0.30).
Note: The call option doesn’t move penny for penny with the futures price change. Futures improved $0.81, but the value of the call option improved $0.40.
Just something to be aware of with options. Their value doesn’t move penny for penny with the market price moves.
Now that we’ve looked at an example, let’s recap some fast facts about call options.
Buying a call…
- means you have the right, but not the obligation, to buy the commodity on the underlying futures contract at the strike price of the option
- gives you an opportunity to capture value if the futures price appreciates
- limits your risk of loss to the premium paid for the option
- is a good strategy to use if you think the market will rally and you want an opportunity to capture value if it does, but want to limit your downside risk to the premium paid for that option