Fortunately, options contracts provide away around both of these problems. Options contracts, which work like insurance that you would buy on your car or home, protect you against unfavorable price moves. For this insurance, you pay a premium to the option seller. The premium is the most that you can lose from the option position and does not require that you post margin funds to maintain the option position.

A. Defining an Option Contract

An option contract is simply a privilege conveyed to its owner. The owner (or buyer) of an option has the right to either buy or sell in the futures market at a specific price. There are two types of options, depending on whether the option owner has the right to buy or sell in the futures markets. A call option gives the owner the right to buy in the futures market at a specific price while a put option gives the owner the right to sell in the futures market at a specific price. The specific price that the option owner has the right to either buy or sell at is called the strike price of the option.

Like futures contracts, there are specific contract months for options. For example, in corn there are option contracts for March, May, July, September, and December. If you were to purchase a $2.50 March corn call option, then you would have the right (but not the obligation) to buy March corn futures for a price of $2.50 anytime between when you originally purchased the call option up until the option expires just prior to March.

The cost of buying the option is called the premium. The premium is the amount of money that the option buyer must pay the seller to receive the option and the rights it conveys. Option premiums vary throughout a trading day as the futures price changes. For any given contract month (e.g., March corn) there are numerous calls and puts traded with different strike prices. The strike prices are in fixed increments of 10 cents for corn and wheat, and 25 cents for soybeans. An example of December corn options are given below for a specific trading day when the December futures price was $2.52. The option premium, which is quoted in cents per bushel and does not include commission charges, differs depending on whether the option is a put or a call, as well as the strike price. As stated earlier, the premium of the option is what changes on a day-to-day and minute-to-minute basis.

December Corn Options when the December Futures Price is $2.52.
Strike Price	Call Premium Cents per bushel	Put Premium Cents per bushel
240	17.5	5.75
250	12.0	10.0
260	8.375	16.0
270	5.875	23.75
280	4.0	31.75
290	3.0	40.5

For example, a 240 December call option has a premium of 17.5 cents. Therefore, if you bought this option, you would have to deposit this amount of money in you futures account (plus commission) to cover the expense. On a 5,000 bushel contract for corn, this would amount to $875. However, unlike with futures, when you purchase an option there is no margin requirement.
Notice from the table above that call option premiums increase as the strike price increases and, conversely, put option premiums decrease as the strike price increases. Call options give the buyer the right to buy in the futures market at the strike price of the option. Therefore, because it is worth more to be able to buy at a lower strike price, lower strike price call options have higher premiums. Similarly, because it is worth more to be able to sell at a higher price, put options with higher strike prices have higher premiums.

Exercising Options and Option Pricing
With an option, the buyer has the right to either buy or sell in the futures market. This right is in effect until the option expires (called the expiration date) which usually occurs about one month prior to the delivery month. Before the option expires, the option buyer has the right to exercise the option and take the position in the futures market. For example, the buyer of a July $3.50 wheat put option could exercise the option (through his broker) anytime prior to June and would obtain a short July wheat futures position at a price of $3.50. If the July futures price was $3.10 at the time, then the futures position would have a $0.40 profit.

Although exercising an option is a possibility for the buyer, it is not necessary to exercise an option. This is because the option premium will reflect the value of being able to exercise the option. Therefore, it is possible to sell the option (as opposed to exercising it) to obtain a profit.

To understand option pricing, it is useful to consider some important terms:

Intrinsic Value--The amount of money that could be currently realized by exercising an option with a given strike price. A call option has intrinsic value if the current futures price is above the option strike price. For example, if a September soybean call option has a strike price of $7.25 and the September futures price is at $7.47, then the call option will have 22 cents in intrinsic value. A put option has intrinsic value if its strike price is above the futures price. For example, if an March corn put option has a strike price of $2.80 and the March corn futures price is at $2.67, then the put option has $0.13 in intrinsic value. When the option expires, the value of the option (whether a put or call), will be equal to the intrinsic value.

In-the-Money--A call or put option that has intrinsic value. For a call option, this is when the futures price is greater than the strike price. A put option is in-the-money when the futures price is less than the strike price.

Out-of-the-Money--A call or put option that has no intrinsic value. For a call option, this is when the futures price is less than the strike price while a put option is out-of-the-money when the strike price is less than the futures price.

Time Value--The time value of an option is the option premium less the intrinsic value. For example, in May let's assume that the December corn futures price is $2.80 and a December $2.70 call option is trading for $0.22. The call option has $0.10 in intrinsic value so the time value of the option is $0.12. As the name implies, the time value reflects the amount of time remaining until expiration.

The table below gives an example of how to compute the intrinsic value and the time value for call options. These prices are for the May corn contract and were taken in January, about 4 months from expiration.

May Call Option Premiums, Intrinsic Value and Time Value when the May Futures Price is $2.76.
Strike Price	Premium (cents/bu.)	Intrinsic Value (cents/bu.)	Time Value (cents/bu.)
$2.60 Call	20	16	4
$2.70 Call	14	6	8
$2.80 Call	10	0	10
$2.90 Call	7	0	7
$3.00 Call	5	0	5

The intrinsic value column is the difference between the current futures price ($2.76) and the option strike price. If this is negative, then the intrinsic value is zero. The time value is just the difference between the premium and the intrinsic value.
Notice that the time value is highest for the $2.80 call option. This is because the $2.80 option is closest to the current futures price. Options that are either significantly in-the-money or out-of-the-money have lower time value because they have a lesser chance of being worthwhile to exercise.

Another important aspect to remember is that the premium of the option at expiration will be only the intrinsic value. Thus, if the futures price at expiration were $2.76 then the call option premiums would become the intrinsic value column and the time value column would be all zeros. Therefore, at expiration of the option, you will be able to sell the option for its intrinsic value.

Options and Insurance
Options contracts are very similar to insurance policies that you would buy on your home or car, for example. Like insurance, you buy option contracts to protect against an adverse price move. If you want to protect against declining grain prices, you could buy a put option which would provide insurance against lower prices.

Like buying an insurance policy, you must pay a premium to the seller. The seller is obligated to protect you in the event that you need price protection. If you own a put option to protect against falling grain prices and the futures price declines, then your put option will increase in value. This is like a payment from your insurance company to protect you from falling prices.
If instead the prices increase, then your option will expire worthless and you will only lose the premium. In fact, the advantage of buying an option over using futures is that the most you can lose is the premium.


B. Using Put Options to Hedge Grain Sales

To protect against declining grain prices, you can use a put option as opposed to selling a futures contract. The put option gives you the right but not the obligation to sell futures anytime prior to expiration. For this right, you must pay a premium which varies according to the strike price of the option, the futures price and the time to expiration of the option.

The advantages of using a put option instead of a futures contract is that the put option will limit your loss from higher prices and will allow you to earn a higher net-price if prices do in fact increase. With a put option, you will be able to set a price floor or minimum price for your grain. There is the possibility of getting a higher price if the futures price increases.

The price floor that you establish using a put option can be calculated from the following formula:

Price Floor = Strike Price of Put + Expected Basis - Put Premium.

To figure out the price floor, you simply take the strike price of the option, add the expected basis (cash price minus futures price) for the time when you expect to sell your grain, and subtract off the premium of the option.
As an example, suppose you wanted to establish a price floor for corn that you will sell a

t harvest time in November. You decide to use a December $2.70 put option. Currently, the December futures is trading at $2.68 and the premium for the $2.70 put option is $0.18. You estimate the basis is +$0.05 which is you best guess for the basis in November. Therefore, the price floor you establish by purchasing the $2.70 put option is:

Price Floor = $2.70 + $0.05 - $0.18 = $2.57.

While $2.57 is the minimum price, there is still the possibility of achieving a higher price if the market is higher than $2.70 in November. To determine what your final net-price will be, you simply take the cash price in November and add any profit or subtract any loss from the options contract.

To illustrate, suppose November rolls around and the market has moved lower so that the December futures is at $2.32 and the cash price in your local market is $2.37 (giving the $0.05 basis). To determine your net-price, you must calculate how much you could sell your option for in November when the December futures is at $2.32. In November, the December option is going to expire so the option premium will consist only of intrinsic value. The intrinsic value for a $2.70 put option when the futures price is at $2.32 would be $0.38. Therefore, you would be able to sell your put option for $0.38 and you only paid $0.18 for it. The profit on your option contract would be $0.20. This $0.20 profit gets added on to your cash price of $2.37 to get a net-price of $2.57. Notice that this is the price floor. In fact, no matter how low the price goes, you will always get $2.57, as long as the basis is as expected. This is because as the market moves lower, the profits you make on the option contract will exactly offset the losses you suffer on the cash market.

What if instead of going lower, prices had gone higher? Let's suppose that in November the December futures is trading for $3.25 and the cash price is $3.30. Because the futures price is above the strike price of the put option, this option would expire worthless because there is no intrinsic value. Therefore, you would suffer a loss on the option of the $0.18 premium that was paid. However, the cash price is higher at $3.30 so your net-price is $3.12. Notice that this is higher than the price floor of $2.57 because the market was higher.

Example of Using a $2.70 December Corn Put Option for a $0.18 Premium
	Lower Prices in November	Higher Prices in November
December Corn Futures	$2.32	$3.25
November Cash Price	$2.37	$3.30
Option Profit (Intrinsic Value-Premium)	+$0.20	-$0.18
Net-Price (Cash + Option Profit)	$2.57	$3.12

C. Choosing a Strike Price for Put Options

In the previous example, the put option used had a strike price of $2.70. However, there are usually a number of different options trading with different strike prices. How do you decide which strike price to use?

To answer that, we must first understand how choosing a different strike price will effect the price floor and the net price. Suppose instead of using the $2.70 put option we use an $2.80 put option for the December corn futures. Because the strike price is higher for the put option, this implies that the premium will be higher. Let's suppose the $2.80 put option is trading for $0.23. The price floor, which is the strike price plus basis minus premium, is:

Price Floor = $2.80 + $0.05 - $0.23 = $2.62.

Notice that this is higher than the price floor for the $2.70 put option. In that case, the price floor was lower at $2.57. Thus, with a higher strike price, you are able to set a higher price floor.

To see how the net price would be impacted by the choice of a higher strike price, we go through the same two price scenarios used earlier. In the first case, prices fall so that the December futures is $2.32 and the cash price is $2.37. The $2.80 put option will have $0.48 of intrinsic value so that is what you will be able to sell the option for at expiration. The cost of the option was $0.23 so the profit is $0.25 which brings the net-price up to $2.62. This, of course, is the price floor.

Consider what happens if instead the December futures price is $3.25 and the cash price is $3.30. Under this scenario, the futures price is higher than the strike price so the option would have no intrinsic value and would expire worthless. The $0.23 loss on the option would be deducted from the higher cash price to get a net-price of $3.07.

Example of Using a $2.80 December Corn Put Option for a $0.23 Premium
	Lower Prices in November	Higher Prices in November
December Corn Futures	$2.32	$3.25
November Cash Price	$2.37	$3.30
Option Profit (Intrinsic Value-Premium)	+$0.25	-$0.23
Net-Price (Cash + Option Profit)	$2.62	$3.07

By using a higher strike price put option, you are able to set a higher price floor. However, there is a tradeoff because you do not benefit as much from higher prices. Notice that with the $2.80 put option, the net-price was $3.07 when prices were high but the $2.70 put option had a net-price of $3.12 under the same price scenario. The reason that a higher strike price option gives you a lower net-price when prices are high is from paying a higher premium. When prices are high, your option will expire worthless (because you do not need price insurance) so when you pay more for a higher strike price option, this lowers your net price.

Is there a right strike price to use? Not really. The choice of which strike price to use depends on your personal and financial situation as well as your expectations about where the market may be when your option expires. From a financial standpoint, your main objective may be to set a price floor above your costs of production. To do so, you may choose a high strike price put option to guarantee that the price you get will not fall below your production costs. On the other hand, you may believe there is a good chance that prices will be higher when your option expires, although you cannot afford a large loss. In this case, you may choose a lower strike price put option which will give you a better net-price if you prices are higher while maintaining some downside price protection if prices do fall.


D. Forward Contracting and Buying a Call

Another strategy which can be used to set a price floor while benefiting from any price increases, involves buying a call option and forward contracting. The forward contract will establish a base price for while the call option will increase in value if prices increase.

To illustrate how this strategy could work suppose you forward contracted 5,000 bushels of corn for February delivery at a price of $3.15. Let's assume that the March futures price is $2.95 when you make this commitment. At the same time that you sign the forward contract, you purchase a $3.10 March call option which has a premium of $0.11. The price floor for this strategy is:

Price Floor = Forward Contract Price - Premium
= $3.15 - $0.11
= $3.04.

The floor price of $3.04 is the minimum price. If prices move higher by February, you could get a higher net-price. This occurs because the call option will increase in value as prices increase.

Suppose in February the March futures price is at $3.35. Because the futures price is higher than the call strike price, the call option will have intrinsic value of $0.25. The profit of $0.14 on the option will be added to the forward contract price of $3.15 to yield a net-price of $3.29.

If instead prices decline, the call option will be worthless at expiration and the loss of $0.11 would be deducted from the contract price to get a net-price of $3.04 or the price floor.

While this example shows what would happen when you simultaneously forward contracted and bought the call option, in practice, you may want to separate the two. For example, you may think that grain prices have reached a peak and will fall lower. Therefore, you decide to forward contract to take advantage of the current price. If prices decline and you suspect prices may bottom and return higher, then you could establish the second part by purchasing the call option. The call option will increase in value if prices increase.


E. Advanced Option Strategies

In some cases you will find that the time value of an option can be high making the price floor from using a put option very low. One way to get around this is to cheapen the put option by selling a call option that is out of the money.

For example, if you buy a $2.70 December corn put option you would simultaneously sell a $3.00 December corn call option. Suppose the $2.70 put option has a premium of $0.25 while the $3.00 call option has a premium of $0.10. When you purchase the put option, as usual, you set a price floor which would be $0.25 under the strike price of $2.70, or $2.45. As the seller of a call option, you would receive the premium of $0.10 and you would have to post margin funds to handle the short option position.
The combination of the long put option and short call option leads to a net-premium paid of $0.15 (put premium bought - call premium sold). Because this is less than the $0.25 premium for the put option, the price floor is higher at $2.55. The downside of this strategy is that the short call option will limit your upside potential. This is because higher prices will cause the short call option to lose money. The call option buyer makes money on increasing prices while the call option seller loses money on increasing prices.
The short call option will set a maximum price or price ceiling for milk sold. This occurs when the price is higher then the strike price of the call. As the price increases, the gains on the cash price of milk will be offset by the losses on the short call option. To figure out the price floor and the price ceiling for this strategy, use the following formulas:

Price Floor = Put Strike + Expected Basis - Net Premium
Price Ceiling = Call Strike + Expected Basis - Net Premium
Net Premium = Put Premium - Call Premium.


To illustrate with the above numbers and assuming a $0.05 basis at harvest in November, the price floor and price ceiling would be:

Price Floor = $2.70 + $0.05 - $0.15 = $2.60
Price Ceiling = $3.00 + $0.05 - $0.15 = $2.90.

The table below illustrates what would happen to the net-price if the futures price were above $3.00 in November or below $2.70 in November.

Buying a $2.70 Put for $0.25 and Selling a $3.00 Call for $0.10
	Lower Prices in November	Higher Prices in November
December Futures	$2.35	$3.40
November Cash Price	$2.40	$3.45
Put Option Profit (Intrinsic Value - Premium)	+$0.10	-$0.25
Call Option Profit (Premium – Intrinsic Value)	+$0.10	-$0.30
Net-Price	$2.60	$2.90

When prices are below the put strike price, then the put option will be profitable and the call option will expire worthless. Because the call option was sold, the seller keeps the full premium of $0.10. The full strategy yields a net-price of $2.60, which is the price floor. Note also that this price floor is higher (by $0.10) than the price floor from only buying the put option.

For the case when prices increase above the call strike price, the price ceiling is in effect. This is because the call option suffers a loss so that an increase in the cash price is offset by the loss on the option. No matter how high prices go, the highest price you can get with this strategy is the price ceiling of $2.90. You can increase the price ceiling (which will decrease the price floor) by choosing a higher strike price call option.

While this strategy has the benefit of increasing the price floor, it does so by imposing a price ceiling and requiring margin funds. Therefore, before using this type of strategy, it is important to recognize its limitations and risks.