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Options 101, Lesson 2

Agriculture.com Staff 02/05/2007 @ 3:21pm

Last week I talked about the bias favoring the purchase of out-of-the-money puts compared to the purchase of out-of-the money calls. This week I will illustrate another way the market favors purchasing puts over calls. To make the seasonal price charts I use in my research, I keep a record of the closing price each day for March corn futures. My records go back to the 1980 futures contract, so I have 27 years of history of that contract. To make the graph, I simply average the price for the whole 27 years for each trading day. My graphs start on April 1 and continue through February 28 of the year of expiration, so I have only 11 months to average.

It would seem logical that over such a long period of years, the average price would go up roughly the same number of days it goes down. That is not the case. The average March corn futures price went down 125 days and up 103 days. It also went down more than it went up. The highest average price during that time came on the fifth trading day of April at $2.74. The lowest price came on the seventh trading day of December. That price was $2.48. That is a total move down of 25 cents from April to December.

The market bids risk premium into the futures price, so the longer there is risk, the higher the price. That does not happen every year. However, it happens a majority of the time so that over a long period of years, the tendency is for the price to go down as time passes and expiration nears. That is why forward pricing works for most farmers most years.

This principle is another way that the market favors purchasing put options compared to purchasing call options. While the premium takes away some of the advantage of forward pricing using put options compared to selling futures, the fact that you do not have the risk of prices rising in a short crop year offsets much of the disadvantage of paying the premium.

Options work best in a trending market. The predominant trend in the corn market is the down trend from April through September. The predominant trend in the soybean market is down from May until early October. Owning put options during these periods has better odds of success than buying calls at any time of year, unless your goal is to cover cash forward contracts or futures hedges. In that case you expect the call option to expire worthless.

Last week I talked about the bias favoring the purchase of out-of-the-money puts compared to the purchase of out-of-the money calls. This week I will illustrate another way the market favors purchasing puts over calls. To make the seasonal price charts I use in my research, I keep a record of the closing price each day for March corn futures. My records go back to the 1980 futures contract, so I have 27 years of history of that contract. To make the graph, I simply average the price for the whole 27 years for each trading day. My graphs start on April 1 and continue through February 28 of the year of expiration, so I have only 11 months to average.

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