ORANGE JUICE OPTIONS: BUYING PUTS

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 FCOJ put options that expire in mid February will be sufficient. The second step is determining the strike price.

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

Reading FCOJ Option Prices

FCOJ options are priced in cents per pound up to two decimals. One FCOJ option can be exercised into one FCOJ futures contract and since each contract is based on 15,000 pounds of orange juice solids, the option price must be multiplied by 150 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 $150 per contract.

For example, the March FCOJ put option struck at 11500 (or 115.00 cents per pound) settled at 1185 meaning 11.85 cents per pound. The dollar value of this option is 11.85 x 150 = $1,777.50. This put option is at-the-money since the March futures contract settled the day at 114.85 cents per pound. Notice that the futures closed lower over the day by 4.50 cents per pound pushing all put option prices higher but that the option prices moved by less than this amount. In fact, this at-the-money put option rose by just 1.8 cents per pound.

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 $1,200 on a March FCOJ put option, then only those options having a strike price of 10500 (or 105.00 cents per pound) or lower would be acceptable.

The potential return is based upon your expectation of how far FCOJ 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 FCOJ put option struck at 11000 (or 110.00 cents per pound). 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 FCOJ 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 FCOJ will fall. Let's say, for example, that you believe March FCOJ can drop to 85 cents per pound by option expiration. Based on this, you would only consider buying put options having a strike price of 9000 (or 90.00 cents per pound) 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 $1,200 and with an expectation that March FCOJ will fall to 85 cents per pound by option expiration, the put options having a strike price within the range of 10500 to 9000 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, 85 cents per pound. Based on this, there are several spreads that can be purchased. For example, the 10000/9000 bear put spread has a value of 4.50 - 1.95 = 2.55 = $382.50 plus commission and fees. If March FCOJ futures is below 90 cents per pound at the time of option expiration, then this spread will close at its maximum value of $1,500 (calculated as 10 cents x $150 per cent). If FCOJ is above 100 cents per pound, 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 FCOJ need not fall so far. For example, the 11000/10000 bear put spread has a value of 9.05 - 4.50 = 4.55 = $682.50 plus commission and fees. FCOJ need only fall below 100 cents per pound at the time of option expiration to earn the $1,500 maximum value of the spread. If FCOJ is above 110 cents per pound, 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 11000/9000 bear put spread has a value of 9.05 - 1.95 = 7.10 = $1,065 plus commission and fees but the maximum value is $3,000 and will be earned if March FCOJ futures is below 90 cents per pound 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: orange juice options, orange juice puts, orange juice put options, FCOJ options, FCOJ put options
Abstract: Orange Juice Options - Examples of buying put options using actual FCOJ prices.