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Option trading

Agriculture.com Staff 11/14/2008 @ 12:34pm

The word options is derived from the Latin word opti meaning choice. Having choices in a trading or hedging strategy can help reduce risk and amplify profit potential. The strength of options is the versatility and flexibility that allows farmers to sculpt hedging positions to their exact needs.

Options are another tool in the drawer that can be used as aggressively or conservatively as you feel comfortable, coupled with what market conditions warrant. Options are meant to be used as a value-added product that can enhance hedging profits and reduce risk.

Options, as a marketing tool, can be used as a leverage or insurance instrument -- as a means for income or simply as a way to set a price floor or ceiling for your crop.

Option contracts enable farmers to adjust or modify trade positions according to whatever situation arises. The biggest benefit of using options is that farmers can custom tailor marketing needs when initiating an options strategy to their exact risk/reward parameters.

However, because traits of an option change with the passage of time, speed and direction of the futures market and changes in the perceive value of options, the characteristic of an option position can change -- sometimes quite dramatically. Trading options is an active hedging strategy that requires continuous monitoring rather than a passive hedging strategy like straight future or over-the-counter hedges that have static characteristics.

For example, if corn prices move from $6.00 to $5.90, it is no different than corn prices moving from $4.00 to $3.90 on a future hedge (10 cents is 10 cents no matter where prices are). But, if you bought a December $5.90 options put at 25 cents on June 1, and December corn prices were at $7.00 on October 1 (way out of the money and likely worthless with so little time left), it would be vastly different than if prices were at $5.80 and questionable whether that option would finish in or out of the money.

The word options is derived from the Latin word opti meaning choice. Having choices in a trading or hedging strategy can help reduce risk and amplify profit potential. The strength of options is the versatility and flexibility that allows farmers to sculpt hedging positions to their exact needs.

The last year or so has seen historically high grain prices and for that matter most commodity markets. The change to an electronic marketplace, massive influx of new money, and an overall increase in demand for hard goods has drastically changed the dynamics of grain and commodity markets. The result has been all-time high prices and volatility has been the norm.

Volatility is defined as the one standard deviation price change in the futures market (or any underlying market) in percent, at the end of one year. So a $10.00 item with volatility at 10% should trade between $9.00 and $11.00, by the end of a year, most (68.3%, by definition) of the time.

Despite what sometimes seems like utter chaos and mayhem, options markets are, in fact, orderly and uniform. There are some basic and easy-to-understand concepts that are essential to understanding the marketplace.

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Scott Shellady: Options 101