CORN OPTIONS: BUYING CALLS

The first step of the purchase decision is to determine the maturity of the call option: it must be long enough to capture the anticipated price rally. Since the rally could span the next several months, you conclude that the March 2010 corn call options that expire in mid February will be sufficient. The second step is determining the strike price.

March corn call options are available across a wide range of strike prices, each having a different cost. (See table at right.)

Reading Corn Option Prices

Corn options are priced in cents per bushel and 1/8 of one cent per bushel. One corn option can be exercised into one corn futures contract and since each contract is based on 5000 bushels of corn, the option price must be multiplied by 50 to get a corresponding dollar value and every one cent change in the price of the option or the underlying futures for that matter is worth $50 per contract. This pricing convention is the same for soybeans, wheat and oats that trade on CME Group so the example for corn provided here can be easily extended to the other grains.

For example, the March corn call option struck at 4000 (or 400 cents per bushel) settled at 30'4 meaning 30 and 4/8 cents per bushel. The dollar value of this option is 30.50 x 50 = $1,525. This call option is nearly at-the-money since the March futures contract settled the day at 395.75 cents per bushel. Notice that the futures closed higher over the day by 16.50 cents per bushel taking all call option prices higher as well but that the option prices moved by less than this amount. In fact, this at-the-money call option rose by just 7 and 5/8 cents per bushel.

As is evident in the table, as the strike price of a call option is raised, its price declines as does its sensitivity to movements in the price of the underlying futures.

Choosing the Strike Price

This requires balancing risk with potential return. The former is simply the cost or purchase price of the option along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $1,000 on a March corn call option, then only those options having a strike price of 4400 (or 440 cents per bushel) or higher would be acceptable.

The potential return is based upon your expectation of how far corn prices will rally. A useful reference is the break-even price. The break-even price of a call option is calculated by adding the option cost and paid trading fees to the strike price. Consider, for example, the March corn call option struck at 4200 (or 420 cents per bushel). If it is purchased at the settlement price shown, then the break-even price of the March futures at option expiration is calculated as:

At option expiration, March corn futures must be above this break-even price in order to profit on the option trade. So, you will only consider call options that have a break-even price below the price to which you expect corn will rally. Since you are expecting a significant rally in corn, this will increase the range of acceptable call options. Let's say, for example, that you believe March corn can reach 500 cents per bushel by option expiration. Based on this, you would only consider buying call options having a strike price of 4800 (or 480 cents per bushel) or lower since otherwise the break-even price is too high.

What remains is the range of acceptable options. In this case, for an investment of at most $1,000 and with an expectation that March corn will rally to 500 cents per bushel by option expiration, the call options having a strike price within the range of 4400 to 4800 would be acceptable to purchase. After the purchase, you will need to manage the option position.

What if there are no remaining options that are acceptable after considering your desired risk and price expectation? Then you can consider buying a more expensive call option and manage the risk, or you can consider buying a bull call spread.

Bull Call Spread

When buying a bull call spread, both strike prices should be below the price to which you anticipate the futures will rise by the time the options expire, in this case, 500 cents per bushel. Based on this, there are several spreads that can be purchased. For example, the 4400/4600 bull call spread has a value of 18 - 13 6/8 = 4 1/4 = $212.50 plus commission and fees. If March corn futures is above 460 cents per bushel at the time of option expiration, then this spread will close at its maximum value of $1,000 (calculated as 20 cents x $50 per cent). If corn is below 440 cents per bushel, then this spread will expire worthless.

Stepping down the strike prices will increase marginally the cost of the spread, but the chance of the maximum value being earned is greater since corn need not rise so far. For example, the 4200/4400 bull call spread has a value of 23 1/2 - 18 = 5 1/2 = $275 plus commission and fees. March corn need only be above 440 cents per bushel at the time of option expiration to earn the $1,000 maximum value of the spread. If corn is below 420 cents per bushel, then this spread will expire worthless.

As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater potential payout by increasing the gap between the two strike prices. For example, the 4200/4600 bull call spread has a value of 23 1/2 - 13 6/8 = 9 3/4 = $487.50 plus commission and fees but the maximum value is $2,000 and will be earned if March corn futures is above 460 cents per bushel at the time of option expiration.

Because the market for option spreads is generally less active than the market for individual options, you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase, you will need to manage the option spread position.

Keywords: corn options, corn calls, corn call options
Abstract: Corn Options - Examples of buying call options using actual corn prices.