SUGAR OPTIONS: BUYING PUTS
Let's say that you have been watching sugar prices fluctuate sideways for several months. You feel that this represents
a significant energy field and that when sugar breaks out of this range, it will move sharply and swiftly.
(See chart at right.) Based on a long-term chart of historical sugar prices, you believe that sugar will break to the
downside and are considering buying a sugar put option to profit should this happen.
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 you're not sure when the breakout will occur, it's best to pick an option with
a few months of life. You conclude that the
March 2010 sugar call options that
expire in
mid February
will be sufficient. The second step is determining the strike price.
March sugar put options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading Sugar Option Prices
Sugar options are priced
in cents per pound up to two decimals. One sugar option can be exercised into one
sugar futures contract and since each contract is based on 112,000 pounds of sugar, the option price must be
multiplied by 1,120 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 $1,120 per contract.
For example, the March sugar put option struck at 2275 (or 22.75 cents per pound) settled at 219 meaning 2.19 cents per pound.
The dollar value of this option is 2.19 x 1,120 = $2,452.80. This put option is nearly at-the-money
since the March futures contract settled the day at 22.67 cents per pound. Notice that the futures closed
higher over the day by 0.76 cents per pound 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 0.40 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 $2,000
on a March sugar put option, then only those options having a strike price of 2200 (or 22.00 cents per pound) or lower would be acceptable.
The potential return is based upon your expectation of how far sugar 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 sugar put option struck at 2125 (or 21.25 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:
21.25 - 1.39 - fee value = 19.86 - fee value.
At option expiration, March sugar 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
sugar will fall. Let's say, for example, that you believe March sugar can drop to 19.00 cents per pound by option expiration.
Based on this, you would only consider buying put options having a strike price of 2000 (or 20.00 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 $2,000 and with an expectation that March
sugar will fall to 19.00 cents per pound by option expiration, the put options having a strike price within the range of 2000 to 2200
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, 19.00 cents per pound. Based on this, there are several spreads
that can be purchased. For example, the 1950/2050 bear put spread has a value of 1.06 - 0.71 = 0.35 = $392 plus commission and fees.
If March sugar futures is below 19.50 cents per pound at the time of option expiration, then this spread will close
at its maximum value of $1,120 (calculated as one cent x $1,120 per cent). If sugar is above 20.50 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 sugar need not fall so far. For example, the 2050/2150 bear put spread has a value
of 1.51 - 1.06 = 0.45 = $504 plus commission and fees. March sugar need only fall below 20.50 cents per pound at the time of option expiration
to earn the $1,120 maximum value of the spread. If sugar is above 21.50 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 1950/2150
bear put spread has a value of 1.51 - 0.71 = 0.80 = $896 plus commission and fees but the maximum value is $2,240
and will be earned if March sugar futures is below 19.50 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.
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March 2010 Sugar #11 Futures
Settle as of Nov 11, 2009: 22.67 Change: +0.76
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March 2010 Sugar #11 Put Option Prices
Prices as of Nov 11, 2009. Source: The ICE
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