Division of Agricultural Sciences and Natural Resources • Oklahoma State UniversityF-549Oklahoma Cooperative Extension Fact Sheetsare also available on our website at:http://www.osuextra.comKim AndersonExtension Agricultural EconomistThe cash price received for most agricultural commodi-ties traded on futures exchanges is determined by the under-lying futures contracts. The following equation may be usedto determine the cash price (OSU Facts Sheet # 548): cashprice = futures contract price + basis. The appropriatefutures contract price directly impacts the cash price.The equation, cash price = futures price + basis is akey to understanding how to use pricing tools (Figure 1). Eachtool and cash price may be thought of as a piece of a puzzle.Just as each pricing tool is connected, each puzzle piece isconnected indirectly to every other piece of the puzzle.For example, the puzzle piece cash price does notchange unless either the futures price or basis changes. If thefutures price increases 5 cents per bushel and the basis doesnot change, the cash price increases 5 cents per bushel.Conversely, if the futures price decreases 5 cents per busheland the basis does not change, the cash price decreases 5cents per bushel.In grain markets, the basis is relatively stable. Majorchanges in the cash price are mostly caused by changes in thefutures contract price. There are many futures contracts. Forhard red winter wheat, there are five contracts; March, May,July, September, and December. The cash price is determinedby the next contract to expire before the expiration month.For example, during December, January, and February,the Kansas City Board of Trade (KCBT) March contract isused to determine the cash price. During March and April, theKCBT May contract is used. During May and June, the KCBTJuly contract is used. During July and August, the KCBTSeptember contract is used. And during September, October,and November, the KCBT December contract is used todetermine the cash price.A key to understanding the market is to understand thissimple principle: The equality, cash price = futures price +basis must hold. Any change in the futures contract price willcause the cash price to change. If the futures price changes,either cash price or basis must change. Producers who owncash commodities (wheat, corn, soybeans, cattle, hogs, etc.)normally lose when futures contract price declines. Produc-ers who must buy cash commodities normally lose whenfutures contract price increases. Futures option contractsmay be used to insure against these losses.Futures Option ContractsAgricultural commodity option contracts traded on theKansas City Board of Trade (KCBT), the Chicago Board ofTrade (CBT), and the Chicago Merchantile Exchange (CME)were introduced in 1988. Their purpose is to provide agricul-Marketing Puzzle:Futures Option Contractstural commodity producers and merchandisers price riskmanagement tools.A futures option contract is a contract which gives thecontract buyer the right (option) to either buy (call option) orsell (put option) a specified futures contract at a contractedprice. Assume a KCBT December $4 wheat Put optioncontract has been bought for 20 cents per bushel. The buyerof the Put has the option to sell a KCBT December contract for$4. Now assume that the December wheat futures contractprice goes to $3.75 per bushel. The buyer of the $4 Put optioncontract has the option to sell the KCBT December contractfor $4 and then buy it back for $3.75, netting a profit of 25cents. After subtracting the original 20 cents costs, the actualprofit from the trade is 5 cents.In this example, the buyer “exercised” the option to buythe futures contract. Very few option contracts are convertedto a futures position (exercised). Most option contracts, whichhave value, are sold. For example, if a $4 wheat Put optionhas been bought and the underlying futures contract is $3.75,the Put option may be sold for at least 25 cents per bushel.The value of futures option contracts changes as theunderlying futures contract price changes. Buyers of futuresoption contracts may use the contracts to insure againstchanges in futures contract or cash prices. Futures optioncontracts are price risk management tools which impact thenet price received through futures contracts. In most cases,profit from buying or selling option contracts goes directly tothe buyer or seller.Futures option contracts provide agricultural producerswith a price risk management alternative for no potential loss,but with unlimited gain. If having an alternative with “nopotential loss” sounds too good to be true, it is. Buyers ofoptions must pay someone to take the price risk. The paymentor premium is paid to the buyer when the option is purchased.Option TerminologyUnderstanding option terminology is not essential toknowing how to use options, but it is important to know theterms when options are incorporated into the marketing plan.Full understanding will come with use. For this fact sheet, youmay refer to the following terms.Buyer—The person who purchases the contract. The buyeris the only person who has the choice of whether or notto use the contract.549-2Figure 1. The Marketing Puzzle.CashPrice=FuturesPrice+BasisForwardContractFuturesContractPutOptionsCallOptionsSeller—The person who sells the contract to the buyer. Thesellers receive the premium (see premium below) and inturn must take the opposite position if and when theoption is exercised.Put—An option contract which gives the buyer the right to sell(short) a specific futures contract at a specified price. Ifrequested, the seller of the put must buy from the buyerof the put option the specified futures contract at thecontracted price.Call—An option contract which gives the buyer of the calloption contract the right to buy (long) a specific futurescontract at a specified price. If requested, the seller of thecall option must sell to the call option buyer the specifiedfutures contract at the contracted price.Underlying Contract—The specific futures contract (i.e.KCBT December wheat) which the buyer has the right to,in case of a Put sell, or in case of a Call buy.Strike Price—The underlying futures contract price at whichthe buyer of the option contract has the right to accept asold position (Put) or bought position (Call). Strike pricesare in 10¢ increments for wheat and corn, and 25¢increments for soybeans.Premium—The “price” of