Chicago, 5 August 2010

Investors and traders looking to gain exposure to wheat and other grains and oilseeds markets typically opt for futures contracts as the vehicle of choice.

But with futures values already looking expensive - not to mention increasingly volatile - the options markets have proved to be an appealing alternate entry point for those looking to gain price exposure to key crops without taking on the risk associated with an outright futures stake.

OPTIONS & RISK - TAKE AS MUCH AS YOU LIKE

One of the key aspects of the options market is that users of them can effectively take on as little or as much risk as they want. The purchaser of an option - say a $4.50 December corn call - needs only to commit to the purchase price of the option concerned - and is not on the hook for any margin calls should the market move away from him as is the case with a futures position. The $4.50 call owner is merely out the purchase price of the option, which gives him the right to purchase December corn futures at $4.50 a bushel at any point prior to the expiration of that option.

The seller, or 'writer' of that call, however, takes on potentially unlimited risk, as that person has committed to selling December corn futures at $4.50 a bushel no matter what the prevailing December futures price may be. So even if December corn surges beyond $6 a bushel for some reason, the call writer must still honor the agreement to deliver December futures at the $4.50 price.

This span in risk from a little to a lot makes the options arena an alluring destination for traders, investors and commercial entities alike, but only after a few of the options markets quirks and intricacies become fully understood.

OUT-OF-THE-MONEY CALLS - THE CHEAP WAY IN?

Traders looking to gain upside exposure to volatile grain markets often opt to buy out-of-the-money call options that give the owner the right to purchase the underlying commodity future at a price above where the market is currently trading.

Because call option prices typically move in the same direction as the underlying future, this strategy allows traders to accumulate price gains on the purchased option while maintaining the ability to turn the option into a long futures position at the designated price should the owner so desire. This strategy has proved to be exceptionally popular lately as the wheat market roared higher with more speed and aggression than market participants had anticipated.

The price of December wheat $8 calls actually outperformed the gains made by December wheat futures during the month of July, rising by more than 1,300 percent on the month from less that 2.5 cents to more than 30 cents. This price advance is made all the more impressive when you consider that December futures were still more than $1 per bushel below that option's strike price at the end of that month.

Wheat was not the only market where out-of-the-money call options outpaced the gains seen in the underlying futures. December $4.50 corn calls gained close to 28 percent in July versus the 20.1 percent gain in December futures, and November $11 soybean calls rose 130 percent to dwarf the 11.1 percent advance in Nov futures for the month of July. Graphics. When considering that these options cost only a few cents per bushel at the beginning of July, it is tempting to view them as a surefire way to ratchet up wins in the commodities arena whenever underlying prices turn higher.

However, as with all things timing is key, as there is an old adage (wives tale?) that says as much as 80 percent of options expire worthless - suggesting that most of the time owning out-of-the-money options is a worthless endeavor.

Further, due to the lower liquidity levels in the options arena versus futures, options prices tend to respond much faster to market sentiment changes than futures values - so it may be too late to pick up a bargain-priced call once futures prices turn higher.

MOVING BEYOND THE JARGON

Implied volatility. Delta. Time decay. At-The-Money. Intrinsic value. All much-used terms by industry insiders that verges on gibberish to amateur investors. For anyone new to the arena it is crucial to look beyond the market lingo and try to decipher what's truly important when you buy or sell an option. Aside from tracking the price of the option itself, as well as the level and direction of the underlying futures market, investors and traders looking to spot appealing entry points for a long out-of-the-money call position need to be mindful of key options market barometers that help offer insight into the tone of the market.

Implied volatility is one of the key tools for determining what the options market is predicting in the underlying futures. In the case of wheat, a wheat option's implied volatility is effectively a measure of the riskiness of wheat futures, and so is a crucial component in setting the price of the options themselves.

As can be seen in the chart below, implied volatility in December $8 wheat calls crept up steadily through June and then into July to hint at an increase in the option market's perception of wheat futures' riskiness. Only after implied volatility had been elevated for some time did the actual price of the $8 calls follow suit, which was then followed by rises in both volume - the number of trades conducted in the market - and open interest - the number of options positions yet to be closed out.

Of course, rises in implied volatility can also equally precede a steep decline in options price, so it is not an indicator of bullishness or bearishness - merely that a change in tone of the underlying market may be brewing.

With that in mind, the below graphic depicting rises in implied volatility for at-the-money wheat, soybeans and corn options suggests additional price volatility may be in the works for those commodities over the coming days. Given the recent steep advances in the futures prices of all three crops, the options arena may well represent an effective way to gain price exposure without paying through the nose.

Ends --

By Gavin Maguire, Reuters market analyst - for Commodities Now.

The views expressed are his own.

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