Understanding and Tracking Options Volatility, Premiums

By Betsy Jensen
Ag Commodity Instructor, Northland Community and Technical College, betsy.jensen@northlandcollege.edu

Many producers understand the basics of put and call options, but that is just the tip of the iceberg.   Using puts and calls in your marketing plan is a great idea, but there are a few more advanced principles you may want to consider before you jump in with both feet.

Option premiums change every day with the futures market, but how are they actually determined?  One of the factors that determines option premiums is volatility. This is where things tend to get a little tricky, but there are some great tools to help you sort through the call and put options.

One of my crop marketing pet peeves is when a farmer tells me “options are just so expensive right now.”  When I ask why, the farmer just shrugs the shoulders and says “well I don’t know, they just are.” You hear it all the time, but what exactly determines whether or not an option is expensive? If you understand volatility, then you can tell me whether or not an option is expensive.

Volatility measures risk, and if the market is trading with large price swings, there is more risk and options will be more expensive. The higher the volatility, the higher the option premium. So think back to last spring when you could have sold new crop soybeans for over $7. You could have also bought put options on your crop, but the option premiums were very expensive, because volatility was so high.

Option volatility can be determined by using Black’s Option Pricing Model. This is a complex formula first published in 1973, and in 1997, it earned a Nobel Prize.

There is a free calculator available online from the Minnesota Department of Ag that you can download onto your computer. The calculator was created by David Bullock, who also sends out monthly volatility reports. I use his calculator and his reports regularly in my marketing groups, and I would suggest that if you are seriously interested in using options in your marketing plans, you should use these tools as well.

You can use the calculator to determine either option volatility, or flip it around and use it to determine an option’s premium at a specific volatility. Here’s an example of how I might use the calculator in my marketing groups.  First I would determine option volatility.  I’d plug in the information such as today’s date, the current market price, the premium of the option, and the calculator spits out today’s volatility. Then I would start to play with the information. What if it is August 1, and wheat has dropped $.50, what would my option be worth?  Or what if wheat takes off on June 1, and volatility increases?  What would I have to pay for this option now?

The best advice I can give is to download the calculator and begin playing.  I recommend using the option page at www.mgex.com to find all the necessary information. This web page includes the risk free interest rate and the expiration date, which is required in the option calculator.   I will warn you that the option calculator can be a little intimidating because of the Greek letters, but don’t worry.  I only look at the letter called Delta, and when I spoke with Mr. Bullock, he has the same advice. “Delta is about as far as you want to go with most farmers,” he said, and there are explanations of the Greeks on the calculator.   

I would also recommend using his monthly option volatility report. It’s a quick and easy way to monitor option volatility. One table available within the report is the Call Option Implied Price Forecast Distribution. While the title might scare a few farmers, it’s really an interesting table to use.  “It’s forward looking. This is what the market thinks the likely range of prices will be,” says Bullock. As volatility increases, so does the likely range of prices.

Understanding volatility can help you make more informed decisions when determining whether or not to buy an option, and also which option to purchase.  Should you buy a July $3.50 put, or a December $3.30 put? Which one is more expensive, based on volatility?  The volatility calculator is also helpful is determining when to liquidate your option. If you think the market will rally $.50, find out what your option will be worth when the futures market rallies $.50, and place your liquidation order today.

I’m not a big fan of options, just because most farmers abuse them.  They purchase options without a clear strategy, and most often end up losing their option premium.  I do use options on my own farm so I do believe they are an excellent tool, if used correctly.  The option calculator and report can help you make more informed decisions about when and how to buy and sell options.  If you participate in a marketing group, I would suggest that your group consider using the options calculator or Bullock’s options volatility report as a discussional topic.  

Jensen puts her marketing plan to work farming with husband Brian near Stephen, Minn.  Her market education activities including this column are supported in part by the Minnesota wheat checkoff, directed by the Minnesota Wheat Research and Promotion Council. If you have a question or topic related to marketing that you’d like to see addressed in this feature, call 1-800-242-6118, or email Jensen: betsy.jensen@northlandcollege.edu .