,19121.50–24.50
1,05718,42510519,58717,3001,10018,4001,18721.50–24.50
Thousand Short Tons24038,21316638,61932,3796,01938,399220181.57
22036,31827036,80832,2564,34036,596212256.05
22539,16016539,55033,9005,40039,300250150.00–180.00
21239,17316539,55033,9005,40039,300250145.00–175.00
Note: Reliability calculations at end of report.1
Marketing year beginning September 1 for soybeans; October 1 for soybean oil and meal.
2
Prices: soybeans, marketing year weighted average price received by farmers; for oil, simpleaverage of crude soybean oil, Decatur; for meal, simple average of 48 percent, Decatur.Source: U.S. Department of Agriculture World Agricultural Supply and Demand Estimates(WASDE-416-13).
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coming to the world market when U.S. farmers are planting their crops in thespring.Acreage and growing weather conditions, especially when the plants are setting and filling pods (August in the United States and January–February in SouthAmerica), are the two main supply factors that influence the market, but they keepmarket watchers busy year-round because of the importance of production in theUnited States (northern hemisphere) and in Brazil, Argentina, and Paraguay(southern hemisphere).Demand for soybeans stems from demand for soybean oil, used in food processing and fast-food preparation, and soybean meal, a primary ingredient in hogand poultry rations.Soybean Oil: Soybean oil is a product of soybean processing when the oilseedis crushed to make oil and meal. Soybean oil is used in food processing for products such as salad dressing and in the fast-food industry as cooking oil.The size of world soybean and other edible oil crops (palm, canola, peanut,sunflower-seed, and cottonseed) are the major supply factors. Expanding personalincome is a strong demand factor in expanding the world’s demand for edible oilseach year in line with population growth.Soybean Meal: Soybean meal is the other product produced when soybeansare crushed at a processing facility. Soybean meal is used mainly as a feed ingredient to boost the protein level of hog and poultry rations. It also is the basis for textured vegetable protein, used in food products.The supply of soybeans determines the potential output of soybean meal production each year. Demand is determined by the feed needs of hogs and poultry,which can be influenced by the number of animals and demand for pork and poultry at grocery stores around the world.Wheat Wheat is the most widely grown crop in the world, with special varieties used to make bread, crackers, noodles, and pasta. Hard red winter wheat,traded at the Kansas City Board of Trade, is milled to make many breads. Softred winter wheat, traded at the CBOT, is used for crackers. Hard red springwheat, traded at the Minneapolis Grain Exchange (MGE), also is used to makebread flours. Because of their specialty use within the wheat flours and theirsmaller production, durum, the primary wheat in pasta, and white wheat, used inthe making of noodles, have more independent market situations than the otherwheat categories.Wheat traders need to have a good grasp of where each variety of wheat isgrown so they can effectively evaluate the impact of weather conditions on the variety they are trading. China is the world’s largest wheat producer but consumesmost of its output domestically. Europe, Canada, Australia, and Argentina are major exporters, and a number of other countries such as Russia, Ukraine, Kazakhstan, and India can have an impact on the export market at times, depending ontheir production during any given year. However, many importing countries lookto the United States, the world’s second largest producer, as their residual wheat
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supplier. Demand for wheat is driven by expanding world incomes and populationas well as nutritional trends.Millers use various blends of wheat to produce flour for numerous wheatbased foods. Therefore, the three major types of wheat being traded on U.S. futures exchanges are influenced not only by their own supply/demand factors butalso by the status of the other two markets. For example, all three markets will beaffected by total acreage planted to wheat, but individual varieties may react morebearishly or bullishly, depending on their own statistics. Wheat also must competewith corn, soybeans, and other crops for acreage, so prices of all the crops tend tomaintain an economic relationship with each other.
LivestockPrior to the 1960s, futures trading was limited to commodities that were storable.That included butter and eggs traded since 1898 at the Chicago Butter and EggBoard, which evolved into the CME in 1919. The CME expanded into frozen porkbelly futures in 1961, the first futures contract based on frozen, stored meats, andbegan to develop its reputation as an innovative marketplace in the mid-1960swhen it introduced futures on live cattle, the first nonstorable commodity, andthen live hogs (changed to lean hogs in 1997). After becoming a world leader in financial futures and electronic trading over the next 30 years, the CME returned toits roots with a revised milk futures contract in 2000.Prices in this sector tend to be quite sensitive to concerns about diets andhealth, as reflected by the nitrite issue in bacon some years ago and, more recently, various mad cow disease scares.Live Cattle Live cattle are market-ready beef animals. The term stems from thecash market practice of quoting prices to producers based on the animal’s weightinstead of quoting prices to meat buyers based on carcass weight.Consumer demand for beef is a long-term factor that influences the live cattlemarket and can be influenced by the supply of competing meats (primarily poultryand pork). On the supply side, it is also important to know how many cattle are inthe feedlots and when they may be coming to market, decisions that are influenced by cattle prices, feed prices, and weather.Health concerns may influence cattle prices in either direction, as seen withdiet fads that promote beef as a protein source or reported incidences of bovinespongiform encephalopathy (BSE), sometimes known as mad cow disease, a disease of cattle first identified in 1986. The number of animals infected with BSEgenerally has been small and isolated, but publicity about even one case can sendprices sharply lower because of worries about the effect on domestic consumption and import restrictions imposed by other nations.Feeder Cattle Feeder cattle are young animals that will be fed to reach marketweight. Feedlot operations buy feeder cattle when they weigh between 600 and
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800 pounds with the intention of feeding them until they reach a market weight of1,100 to 1,200 pounds.From the supply side, the number of cows in the United States determineshow many calves will be born each year. Also, the long-term outlook for cattleprices and feed prices may influence how many heifer calves are held back forbreeding purposes rather than sent to feedlots.Demand for feeder cattle varies with the outlook for live cattle prices and thecost of feeding the animals to reach market weight.Lean Hogs The value of the meat produced by market-ready hogs that havebeen fed to the packers’ desired weights of about 230 to 260 pounds is the difference between “lean” and “live” hog prices. Because bones and waste representabout 26 percent of a typical hog, live prices are normally 74 percent of a lean hogprice quote. Increasingly, the cash hog market is being quoted in lean values ratherthan live-weight prices.Consumer demand is the major long-term factor that drives the lean hogmarket. Personal income, the supply of competing meats (primarily poultry andbeef), and health concerns influence individual purchases. It’s also important toknow how many pigs are being farrowed and fed to market weight and whenthey may be sold, decisions that are influenced by lean hog prices, feed prices,and weather.Pork Bellies A pork belly is the underside of a hog (beneath the ribs) that isused to make bacon. Each hog produces two pork bellies that are then cured,smoked, and cut into strips of bacon.The supply of pork bellies, both fresh and frozen, is a key market factor. Demand remains relatively steady throughout the year except for a blip up during“BLT” season as home garden tomatoes ripen in late summer. The CME started afresh pork belly contract in April 1997, but the previous frozen belly contract remains the dominant futures contract in this market so far.Milk The CME replaced its Basic Formula Price (BFP) milk futures contractwith a Class III milk contract in January 2000 to reflect the price of milk used inthe manufacturing of cheese under the federal government’s revised milk priceclassification system. Volume in milk futures, a 200,000-pound contract, at timesmatches or exceeds activity in pork belly futures. Traders watch cash cheese andbutter markets to get pricing indications for futures.
Food and FiberAlso known as tropical commodities because of where they are grown, thisgroup of commodities is traded at the New York Board of Trade and in Londonon Euronext.liffe. Production is concentrated in less-developed countries, sometimes influenced by political factors, and demand comes primarily from Western
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developed nations, with interaction between the two mostly responsible for determining prices in this sector of the commodities market.Cocoa Cocoa is a tropical commodity that is the basis for manufacturing chocolate candy and other cocoa products, including cosmetics and pharmaceuticals.Cocoa trees usually are planted within 20 degrees of the equator. Beans are firstproduced on the trees after four to five years, but the tree does not reach maximum productivity until it is eight to 10 years old. Africa’s Ivory Coast is the world’sforemost cocoa producer, with its neighbor Ghana a distant second.Weather conditions, disease, insects, and producer crop management techniques have a direct impact on the size of the cocoa crop. Political and economicconditions in the producing countries can sway production plans. Demand isstrongest in the Netherlands, followed by the United States, Germany, and theUnited Kingdom.Coffee The coffee that many people need to get their day started gets its start asa coffee bean grown on trees or bushes in subtropical climates. Trees begin tobear two to three years after planting, reaching their full potential in four to eightyears; trees may produce for 20 to 30 years. The world’s primary type of coffee,arabica, is grown mainly in the western hemisphere, with Brazil and Colombia theleading producers. Robusta coffee, which has a stronger flavor than the arabicas,is produced in Asia and Africa. Vietnam has emerged as a major coffee producerand exporter in recent years.Coffee demand is largely inelastic, with consumption changing significantlyonly when prices rise or fall dramatically. Still, with an expanding number ofgourmet coffee shops, U.S. coffee consumption is on an upswing, according tocoffee industry statistics.Weather conditions, particularly the potential for a killing freeze, in the primary growing areas can influence prices. Long-term health of the coffee trees andharvesting practices also affect the supply of coffee. Government policies in theproducing countries and producer groups also influence long-term production decisions and export quotas.Cotton Cotton is a fiber crop grown annually for fabric for clothes and othercotton goods, with cottonseed oil being an important by-product. The UnitedStates and China are the world’s two largest cotton producers. Cotton has a longhistory in international trade, including the relationship between England and theColonial United States. Cotton reached its record high price of $1.89 per poundduring the Civil War; cotton futures first opened for trading in 1870.Acreage planted to cotton in the main producing countries as well as growingseason weather are the main factors to watch for their effect on prices. Government policies controlling the amount of imports into the United States also influence prices. Demand for cotton-based clothes and goods is sensitive to consumerpreferences and economic conditions.
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Frozen Concentrated Orange Juice (FCOJ) FCOJ is what millions ofAmericans pull out of the frozen food section at their grocery stores and mixwith water to make orange juice for the breakfast table. The process that eliminated the need to squeeze fresh oranges for juice every morning was developedjust after World War II ended. The United States and Brazil dominate world orange production and world FCOJ trade. Newly planted orange trees producemarketable fruit in three to five years but don’t reach their peak until they are 15to 20 years old.FCOJ prices are more weather sensitive than other markets. From Decemberthrough March, a frost or freeze in Florida can have a disastrous effect on both thecurrent crop size and long-term production prospects. Similarly, Brazilian orangetrees are at risk from drought from July through November.Shifts in consumer preferences among juices and other beverages influencedemand for FCOJ. Internationally, exchange rates versus the U.S. dollar affectdemand. Processing capacity also is a consideration, particularly as a shortterm factor.Sugar Sugar is a sweetener used in the baking and confectionery industries aswell as in the home. It also can be converted into industrial alcohol fuel. Sugarcomes from both cane and beets. Sugar cane is a bamboo-like grass grown insemitropical regions of the world. Sugar beets are grown mainly in Europe, Russia, and Ukraine.Production of both sugar cane and sugar beet crops can be affected by weather,disease, insects, and cultivation practices. World trade in sugar is highly dependenton government policies, such as import tariffs. Sugar demand is affected by consumer income, candy and confectionery sales, and competing sweeteners, such ashigh-fructose corn syrup. Demand for industrial alcohol production can reduce theamount of sugar processed for sweetener purposes.
CHAPTER 9
Optionson FuturesA Flexible Trading Tool
I
f you’re surprised to find a chapter on options in a book about futures, you’renot alone. Clients new to futures are often unaware they can invest in futuresoptions. In fact, they sometimes doubt they heard right: “Options on futures—how can that be? I thought they were two different things.” This confusion willarise because one of the first lessons taught about futures is “they are not the sameas options.”Futures and options are indeed different investment vehicles—just as futuresare different from real estate, bonds, or stocks. But these latter four investmentclasses share one common feature: Each can have an option based on it.For instance, if you have found a house to buy, you may first negotiate to buyan option on the property, which will give you the sole right to buy that house at acertain price and by a specified time in the future. That is an option on real estate.If you are looking to invest in a local business you can instead purchase an optionto buy, allowing time to fully analyze the books. That is an option to buy into anownership interest.Perhaps you’re more familiar with options on stocks, a mature and popular industry considered mainstream by many investors. Buying a call option providesthe right to purchase the underlying stock at a specified price and time; buying aput option gives you the right to sell it at a particular price and time. Options inmany forms abound, and each can have a role to play in an efficiently diversifiedportfolio. And so it is with options on futures as well.Futures options are just what they sound like—an option based on pricechanges of an underlying futures contract. They trade on regulated exchanges sideby side with the futures on which they are based. Their value is calculated usingthe same variables as other types of options (more on that later). Any futures contract can have options traded on it, although not all do.139
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The futures industry is growing by leaps and bounds, and more significantly,options on futures are expected to enjoy an even greater rate of growth in thecoming years. Any book about futures would be lacking indeed without a chapteron futures options.Now that you’re over the initial shock of “options on futures,” let’s explore thesubject a bit more.
ISSUES TO CONSIDER WHEN INVESTING IN FUTURES OPTIONSIf you’re new to options, don’t worry. This chapter will review the basics andwill describe exactly what an option is. You’ll learn the difference between callsand puts, and the essentials on how they are valued. You’ll gain an overview ofhow different factors, such as changes in interest rates or volatility, can affectoption values.This chapter has three sections. We’ll cover the mechanics of options in section two and then review some common trading strategies in section three. We begin first with some general discussion on issues important to options investors.
Think Like an Options TraderIt has been said that options traders don’t think like the rest of us. Maybe that’sjust some industry humor, but there’s always a bit of truth in humor. Options investors not only care about where a market is going, they are equally concernedwith how it will get there.The reason is twofold. First, an option price depends in part on the volatilityof the instrument it’s based on. If a volatile market rallies for two months but withever-smaller ranges (decreasing volatility), an option buyer who picked the direction correctly may still lose money on the investment because options are pricedlower on calm markets than on volatile markets.Second, and equally significant, is the fact that options lose value over time.All things being equal, every week that goes by means the options have lost moretime value. Considered another way, at any given moment an option has pricedinto it the probability that the underlying market will move in its favor. Everyweek that passes where the market fails to move favorably is another week wherethe option has lost some of that value. These two issues—volatility and timevalue—will be explored further in the section on the mechanics of options, but understanding these concepts is an important first step in learning about options.
Why Trade Options?Like futures markets, organized options markets are an integral part of an advancedand developed economy. Any business faces both risks and costs of business, and an
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efficient economy will have mechanisms in place for business to lay off those risksand costs. Options markets provide valuable hedging and balancing functions for institutional and commercial enterprises with real business needs. But what aboutyou, the average individual investor?You’re simply looking to make money, and there’s nothing wrong with that. Infact, much of the daily trading volume comes from speculators like you, who addliquidity and efficiency to the marketplace. It takes many participants, all tradingfor their own valid reasons, to create a marketplace. But the process is never easy.Let’s dispel some common myths about options.
Some Common Options MythsInvestors new to options often learn from the school of hard knocks some ofthe lessons addressed here. It’s best to consider these matters early in the chapter to provide some context to the mechanics and strategies sections. Here is ashort list of what we consider to be some of the more common myths about options investing.If the Underlying Market Goes My Way the Option Will Gain in ValueIn other words, in rising markets the call options will naturally increase in value,and in falling markets the puts will make money. This is not always the case.Choosing the market direction is a very important factor, of course, butequally crucial can be those issues of time value and volatility. You don’t want tobe an options investor surprised by losses because you focused only on the priceof the underlying futures contract and not on the option price as well.Buying Options Has Limited Risk and Therefore Is Safer than Selling Options While it’s true that buying an option has a limited amount of risk,the amount of that risk is quite substantial—100 percent of the option value! Doesthis limited-risk feature of buying an option mean the strategy is less risky thanone of selling options (also known as “writing” or “granting” options)? Not necessarily. Perhaps a better mind-set is to say that by buying an option you can defineyour risk.The reason is that risk and safety can be measured in different ways. Many options have a high probability of expiring worthless. In such instances, some will argue it is option buyers who take the greater risk because they will have to sufferthrough many losses before hitting upon the windfall profit they hope will arrive.Conversely, while it’s true that some option-writing strategies can have lessvolatility and a higher probability of positive returns than option-buying strategies,the risk is unlimited. In fact, options writers could lose more than the value oftheir account! One big surprise loss could wipe out many months’ worth of winners in a single stroke of misfortune.Options strategists apply one method rather than another (options buying oroptions selling) depending on circumstances, but ultimately the outcome of any
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given trade is unknowable and inherently risky, regardless of whether you are anoption buyer or a seller.Options Are Very Complicated and Difficult to Understand As youknow by now, several factors influence the value of an option. What’s more, different options can be matched in combinations to create unique and varied strategies. However, the good news is that each individual strategy is usually verystraightforward and easy to understand.To understand a particular strategy simply plug in and solve the profit or lossof that strategy for a variety of different scenarios—the market is higher, lower, orsomewhere in between, or the market is unchanged after two weeks have passed.You’ll find examples of how to do this in the strategies section later in the chapter.Successful Options Trading Requires Fancy Computers to EvaluateOpportunities Don’t get hung up on the mathematics and the “Greeks” ofoptions trading. We’ll mention them in this chapter but much of what you needas a practical matter can be gleaned by tracking both the option price itself andthe price of the underlying future. Besides, even the most advanced option pricing models are only as good as the data fed into them—the human part of theequation.More importantly, every option strategy—from the simplest outright optionpurchase to the most complicated option spread—relies ultimately upon the investor forecasting the market.Buying Underpriced Options and Selling Overpriced Ones Provides aValuable Edge in Trading Options Would you like a surefire way of knowing what an option is worth? Experienced traders have this terrific way of knowing what something is worth, and we share with you now this powerful technique.In fact, you can use this simple, universal formula to also discover what yourhome, automobile, or time-share is worth.Using your home as an example, here is the formula: Your home is worthwhat someone is willing to pay for it.Think about this a bit. You may believe your home is worth more than whatbuyers are offering, but until the marketplace agrees with you there is little youcan do about it. As the old adage says, “The market is always right.” How oftenhave you seen a market move seemingly too high or too low only to see the movedouble or triple from there? Markets can trend, especially in futures markets, for asurprisingly long time.The market will price options for a reason. Even if that reason is not readilyapparent to you, if prices diverge from their theoretical value that in itself is valuable information. For instance, if stock index puts are overpriced when compared against the calls, the market is saying the risks of a big sell-off are high. Thesell-off may or may not happen, but puts should not be sold short just becausethey are expensive. Equally, if overall volatility is at an all-time low then options
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will be cheap, but that in itself does not indicate the time has come for prices tobreak out actively.Buying Options Is a Good Way to Protect Against the Risks of Existing Futures Positions Investing is a risky business. And where there arerisks, there are often ways of protecting against those risks. You may have heardthat buying an option can help safeguard against risks you may be facing. Unfortunately, some investors overestimate the extent and nature of the protectionachieved from buying options.If you’re trying to avoid the risks of corrections that are typical in daily andweekly market activity, buying options may actually be a needlessly expensiveway to lower your exposure in a position. For example, if you are long 10 euro currency futures and are worried about a sell-off, you might choose to buy 10 puts tohelp shield the position. In a worst-case scenario where the futures position goesterribly wrong against you, at some point the puts will fully defend you against additional losses. This is an example where buying options does indeed provide protection against a big loss becoming a catastrophic loss.But, what about the more common everyday risks of trading? In our example,buying the puts may hedge the long 10 futures contracts into a net long position ofonly 7.2 futures. But, if you’re buying puts to lighten your exposure in the eventthat futures might drop back to last week’s lows, why not start out with only sevenlong futures? Why buy 10 futures and then pay money to decrease the risk of thatposition back to about seven contracts?Don’t get the wrong idea here; if you are truly concerned about the risk of acatastrophic loss, then buying puts will certainly provide you with protection fromthat worst-case scenario. However, buying puts to avoid typical market volatilitycan wind up being an added expense that doesn’t really work, anyway. Althoughthe smaller, unhedged position (seven contracts in our example) still has unlimited loss potential in the event of a catastrophic meltdown, some investors willchoose instead to manage the risks with active money management.To think like an options trader, you must always be careful that you are buyingoptions for the right reasons. The cost of an option, referred to as its premium, candefinitely be thought of as an expense. You pay monthly premiums for automobile,life, and mortgage protection because you have a real and preexisting need to doso. But, if choosing to have a position of 10 contracts means you’ll then need tospend money to lessen that risk, perhaps the better choice is to simply begin witha smaller position.
Options Strategies and Decision MakingIn Chapter 2, “Becoming a Futures Trader,” you read about the issue of art versus science and how it ties in with achieving your goals as an investor. The issueis especially germane when discussing futures options. Because options takeinto account variables other than just the direction of the underlying market, an
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investor has more details to learn when studying the mechanics of options.That’s the “science” part of the equation, and much of this chapter deals withthese essential details.The “art” part of the equation is a little more difficult to master and may bewhat separates the beginners from the experts. While this chapter introducesyou to some of the key issues and concepts about when certain strategiesare best used, it will be your task to develop the art of decision making furtherover time.The general issues discussed so far can be helpful as you begin investing infutures options. Still, you’ll need a basic appreciation of the mechanics of futures options to build a foundation for understanding options strategies. Thelast part of this chapter introduces you to some of the more popular and wellknown of those strategies. But now let’s take a look at the basic mechanics ofhow options work.
MECHANICS OF FUTURES OPTIONSIf you understand stock options you’ll have no problem with futures options, because they operate in exactly the same way. The only distinction is they are basedon a different underlying instrument—in this case a futures contract, not a stock.
What Are Futures Options?There are two types of options—call options and put options. With both types it isthe buyer who gains rights and the seller who is assigned the obligation to fulfillthose rights. We’ll state the obvious by pointing out these rights and obligationsare incurred only when a position is on. In a liquid market, options may be boughtand sold as frequently as the investor deems appropriate, and offsetting a positionis the most common way of removing an obligation or a right.A call option gives the buyer the right to purchase the underlying futures contract at a specified price (the strike price) and within a certain time (on or beforethe expiration date). A put option gives the buyer the right to sell the underlyingfutures contract at the strike price on or before the expiration date. Clearly, thecall buyer expects a market rally and the put buyer seeks a pullback.As with any transaction, there is a seller for every buyer. Just as the call buyerexpects a market rally, the one who sells it hopes the rally does not occur. The callseller is obligated to sell the underlying futures at the agreed-upon strike price—even if it has rallied considerably from the time the deal was originally made.And just as the put buyer expects a market to drop, the put seller is hopingthis does not happen. From the seller’s view, a put option is an obligation to buythe underlying futures at the agreed-upon strike price—even if the market has subsequently dropped.
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The option buyer pays money for the option and the seller receives thatmoney. So the most the option buyer can lose is the cost of the option (the premium paid). The most the option seller can make is the amount of premium received. Of course, the option can increase in value an unlimited amount, which thebuyer hopes will happen and the seller hopes will not. So the option buyer has unlimited profit potential and the seller has unlimited corresponding risk of loss.Why then would someone be willing to sell options if the gain is limited and therisk is unlimited?The reason is that each position (long options or short options) is really just adifferent reward/risk profile. Stated another way, one position is not necessarilymore risky than the other, only different. As you’ll see, factors work to keep therisks balanced. For instance, time decay works in favor of the options seller, sothere may be many winning trades in a row before a setback from a large losscomes along. In theory, the market prices the options so that an investor should beindifferent about whether it is better to be a buyer or seller.Since everyone already knows the rights and obligations, the only issue left tonegotiate is, how much money should the option be worth? Of course, differentoptions will have different values, and those values depend on the particulars ofeach option. Luckily, for exchange-traded options these terms are standardized,simplifying the process of trading. Let’s consider now how those different termsfactor into the value of an option.
Determining the Value of an OptionA detailed discussion of the math behind options is beyond the scope of this chapter. Many excellent books are available on this topic, and anyone serious about investing in options should become familiar with the mathematics of optionspricing. By avoiding much of the math, this chapter will instead explain optionvariables in terms that are both intuitive and practical.On the most basic level, an option price is determined primarily by threethings: the price of the underlying instrument it is based on, the volatility of thatunderlying instrument, and the amount of time remaining on the option. Prevailinginterest rates also factor into the option pricing formula. And the big wild card invaluing options is the supply and demand situation in the marketplace. We’ll consider each of these in order.Price of the Underlying Futures Contract Clearly, the price of the underlying futures is the main factor in an options price. You know this intuitively