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OPTIONS TRADING STRATEGIES
BUYING CORN PUT OPTIONS
Let's say that, after reading a report on expected crop yields and international consumption demand, you are bearish on corn.
The recent price retreat from 425 cents a bushel has convinced you that the market will be heading lower. (See chart at right.)
The price decline could be significant and continue over the next few months. To profit should this happen, you are considering
buying a corn put option.
The first step of the
purchase decision
is to determine the maturity of the put option: it must be long enough to capture the anticipated price drop.
Since the price decline could span the next several months, you conclude that the
March 2010 corn put options that
expire in
mid February
will be sufficient. The second step is determining the strike price.
March corn put 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 put option struck at 4000 (or 400 cents per bushel) settled at 34'6 meaning 34 and 6/8 cents per bushel.
The dollar value of this option is 34.75 x 50 = $1,737.50. This put 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 pushing all put option prices lower but that the option prices moved by less
than this amount. In fact, this at-the-money put option fell by just 8 and 7/8 cents per bushel.
As is evident in the table, as the strike price of a put option is raised,
its price increases
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 put option, then only those options having a strike price of 3700 (or 370 cents per bushel) or lower would be acceptable.
The potential return is based upon your expectation of how far corn prices will fall. A useful reference is the
break-even price.
The break-even price of a put option
is calculated by subtracting the option cost and paid trading fees from the strike price.
Consider, for example, the March corn put option struck at 3800 (or 380 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:
380 - 24 - fee value = 356 - fee value.
At option expiration, March corn futures must be below this break-even price in order to
profit on the option trade.
So, you will only consider put options that have a break-even price above the price to which you expect
corn will fall. Since you are expecting a significant drop in the price of corn, this will increase the range of acceptable put options.
Let's say, for example, that you believe March corn can drop to 320 cents per bushel by option expiration which is the low
on the chart above.
Based on this, you would only consider buying put options having a strike price of 3300 (or 330 cents per bushel) or higher since otherwise the break-even price
is too low.
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 fall to 320 cents per bushel by option expiration, the put options having a strike price within the range of 3300 to 3700
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 put option and manage the risk, or
you can consider buying a bear put spread.
Bear Put Spread
When buying a bear put spread, both strike prices should be above the price to which
you anticipate the futures will fall by the time the options expire, in this case, 320 cents per bushel. Based on this, there are several spreads
that can be purchased. For example, the 3500/3300 bear put spread has a value of 12 2/8 - 7 1/8 = 5 1/8 = $256.25 plus commission and fees.
If March corn futures is below 330 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 above 350 cents per bushel, then this spread will expire worthless.
Stepping up 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 fall so far. For example, the 3700/3500 bear put spread has a value
of 19 4/8 - 12 2/8 = 7 1/4 = $362.50 plus commission and fees. Corn need only fall below 350 cents per bushel at the time of option expiration
to earn the $1,000 maximum value of the spread. If corn is above 370 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 3300/3700
bear put spread has a value of 19 4/8 - 7 1/8 = 12 3/8 = $618.75 plus commission and fees but the maximum value is $2,000
and will be earned if March corn futures is below 330 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.
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March 2010 Corn Futures
Settle as of Nov 2, 2009: 395.75 Change: +16.50
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March 2010 Corn Put Option Prices
Prices as of Nov 2, 2009. Source: CME Group
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