What Are Options? From a Farmer's Put to the S&P 500

The narration of the video, as text.

0:00The question

Spring. The wheat goes into the ground now, and it will be sold in autumn. By then, the price could double, or halve. How do you protect yourself from the fall, without giving up the rise?

0:14Welcome

Welcome to the LiveGexLevels options school. One idea at a time, from the first contracts in history to the strategies traders use today. This is education, not advice. You decide, and you trade with your own broker.

First episode: where options come from. Today we take the side of someone who buys an option to protect themselves, like the farmer who sowed that wheat. We'll see what an option is, who sells it, who guarantees it, and why it works like insurance.

0:58In the farmer's shoes

Put yourself in the farmer's shoes. You've already paid for the seed, the fuel, the work. In autumn you'll have a hundred tonnes of wheat to sell. That wheat is your underlying. Until you sell it, its price moves freely, up or down. Today wheat is worth 100 a tonne. If by autumn it falls to 60, you can't even cover your costs. If it climbs to 140, it's a great year. So what you need is simple. A minimum price, in case it falls. And the rise, if it comes.

1:35Fixing the price: the forward

The oldest answer is an agreement. You find a buyer and fix the price today, say 100, for delivery in autumn. It's called a forward contract. In Osaka, in 1730, the shogun authorised a market in rice for future delivery, the ancestor of today's futures exchanges. Chicago's Board of Trade, founded in 1848, did the same with grain. If wheat falls to 60, the buyer still has to pay you 100. The forward protects you from the fall. But it cuts both ways. If wheat goes to 140, you still have to sell at 100. You've given up the rise, and both sides are bound.

2:22The put: a right to sell

An option adds just one thing. A right, without the obligation. Here, the farmer buys a put. You keep your wheat, with its price free to move, and add a put to protect yourself from the falls. The right to sell the harvest at 100, the strike, by autumn. The right isn't free. Today you pay a premium, say 5 a tonne. Now it's autumn. If wheat has crashed to 60, you use your right and sell at 100. Whoever sold you the put has to buy at 100. Net of the premium, you get 95. That's your floor, the minimum price you needed. If wheat has climbed to 140, nothing forces you to sell at 100, as the forward did. You let the put expire and sell at 140 on the market. Minus the premium, 135. The rise is yours. And if it's still around 100, you sell there, and the premium was the price of sleeping well. That's the answer to our opening question. And it isn't just theory. Some farmers do it today, especially the larger ones, with puts on grain futures, or with minimum-price contracts that work in a similar way. Big funds do the same with puts on the S&P 500, as we saw in our episode on who moves the price.

But who sells the farmer this right? There must be someone on the other side, a counterparty. A wheat buyer, a merchant, a speculator. They collect the premium, and in exchange they take on the obligation to buy at 100 if, in autumn, the price is below 100. If it isn't, they keep the premium and buy nothing. That's their pay for the risk. But if wheat crashes to 60, who guarantees they'll really pay 100? Today it's the exchange's clearing house. It stands between buyer and seller, and asks the seller for a deposit, the margin, so the promise is kept.

And a detail many people miss. A put protects the price, not the quantity. If hail destroys the crop, the put won't pay you back for what you lost. For that there's crop insurance. And that other risk, the bad harvest, is exactly what a law of Hammurabi covered, nearly four thousand years ago. If a storm or a drought destroyed the crop, the farmer could skip that year's loan payment.

4:56From the harvest to the S&P 500

Paying a little today for a right tomorrow is a very old idea too. Aristotle tells of Thales of Miletus, who expected a great olive harvest. Thales paid a small deposit for the right to use the olive presses, and when the harvest came, rented them out at whatever price Thales liked. It was a bet, not protection. Calling it an option is our modern reading.

From crops, options moved on to shares. In Amsterdam, in the sixteen hundreds, traders were already dealing in options on the Dutch East India Company. Then, a twist. In 1936 the United States banned options on farm products, as pure speculation. A tool that could protect farmers, banned on their own crops, until 1982. And a detail few people know. The modern market opened in Chicago on the twenty-sixth of April, 1973, in the former smoking lounge of the Board of Trade. On day one, 911 contracts changed hands. Calls only, the right to buy, on 16 stocks. Options on the S&P 500 followed in 1983. And since 2022 there's an expiry every trading day, the 0DTE, options with zero days to expiry.

6:19Four words

So, what did the farmer buy? An option. And every option comes down to four words. The underlying, anything with a price. Wheat, oil, gold, a share, an index. The strike is the price that's fixed. The expiry, the date. And the premium, what the right costs. For the farmer, that's wheat, 100, autumn, and 5 a tonne.

There are two kinds. The farmer's is a put, the right to sell at the strike. A call is the opposite, the right to buy. Whoever buys an option holds the right. Whoever sells it collects the premium and takes on the obligation, and the clearing house stands in between. Options on the S&P 500 index, the SPX, are European and settled in cash. They're exercised only at expiry, and nobody delivers five hundred companies. Just the difference between the strike and the index, in money. Options on SPY and on the futures follow other rules.

Two things to keep in mind. Protection has a price. If at expiry the price is above the strike, the premium is gone, like insurance on a house that never burns. And the premium tells you something. How far the market thinks the price could travel by expiry. Not where it will go, but how far it could go. That's called volatility, and we'll come back to it.

7:53In brief

In brief. The farmer needs a minimum price, without giving up the rise. A forward fixes the price for both sides, but the farmer gives up the rise. A put gives the right to sell at the strike, for a premium. A floor below, and the rise kept. Like insurance. On the other side, someone collects the premium and takes the obligation, and the clearing house guarantees both. On the S&P 500, that someone is usually a dealer, who doesn't want to bet on the direction, so they cover the risk by buying or selling the underlying. That's called hedging. LiveGexLevels estimates where that hedging piles up on the S&P 500, during the session.

8:41Up next

Next episode: the long call, the first option ever listed. Why its curve looks the way it does, and what time and volatility do to it. We take requests, so tell us in the comments what you'd like us to explain. Before risking real money, practise with paper trading. And the guide is free with our newsletter, on livegexlevels.com.