Ethanol Options Explained

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Contents

Ethanol Options Explained

Ethanol options are option contracts in which the underlying asset is an ethanol futures contract.

The holder of an ethanol option possesses the right (but not the obligation) to assume a long position (in the case of a call option) or a short position (in the case of a put option) in the underlying ethanol futures at the strike price.

This right will cease to exist when the option expire after market close on expiration date.

Ethanol Option Exchanges

Ethanol option contracts are available for trading at Chicago Mercantile Exchange (CBOT).

CBOT Ethanol option prices are quoted in dollars and cents per gallon and their underlying futures are traded in lots of 29000 gallons of ethanol.

Exchange & Product Name Underlying Contract Size Exercise Style Option Price Quotes
CBOT Ethanol Options 29000 gal
(Full Contract Specs)
American N.A.

Call and Put Options

Options are divided into two classes – calls and puts. Ethanol call options are purchased by traders who are bullish about ethanol prices. Traders who believe that ethanol prices will fall can buy ethanol put options instead.

Buying calls or puts is not the only way to trade options. Option selling is a popular strategy used by many professional option traders. More complex option trading strategies, also known as spreads, can also be constructed by simultaneously buying and selling options.

Ethanol Options vs. Ethanol Futures

Additional Leverage

Limit Potential Losses

As ethanol options only grant the right but not the obligation to assume the underlying ethanol futures position, potential losses are limited to only the premium paid to purchase the option.

Flexibility

Using options alone, or in combination with futures, a wide range of strategies can be implemented to cater to specific risk profile, investment time horizon, cost consideration and outlook on underlying volatility.

Time Decay

Options have a limited lifespan and are subjected to the effects of time decay. The value of a ethanol option, specifically the time value, gets eroded away as time passes. However, since trading is a zero sum game, time decay can be turned into an ally if one choose to be a seller of options instead of buying them.

Learn More About Ethanol Futures & Options Trading

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Ethanol Options Explained

Bearish strategies in options trading are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy.

Very Bearish

The most bearish of options trading strategies is the simple put buying strategy utilized by most novice options traders.

Moderately Bearish

In most cases, stock price seldom make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilise bear spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ.

Mildly Bearish

Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price do not go up on options expiration date. These strategies usually provide a small upside protection as well. A good example of such a strategy is to write of out-of-the-money naked calls.

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Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

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Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

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What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

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Understanding the Greeks

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Last Updated on October 29, 2020

Why is Ethanol Valuable?

Ethanol is a clear, colorless alcohol produced mostly from grains or sugar. Since it is made from biomass (*organic material derived from plants and animals), it is considered a renewable energy. Ethanol is often blended with gasoline or diesel fuels to produce a cleaner-burning fuel for automobiles.

The history of ethanol as a fuel source dates back almost 200 years. In 1826, inventor Samuel Morey first used ethanol to power an engine, and in the 1850s, ethanol competed with kerosene as a lighting fuel. However, liquor taxes enacted during the US Civil War made ethanol no longer economically viable as a fuel.

In 1906, the repeal of the liquor tax briefly revived interest in ethanol. In 1908, Henry Ford engineered the Model T, an early automobile, to run on a blend of gasoline and alcohol. However, the passage of Prohibition in 1919 banned the sale of alcohol and effectively ended the ethanol market.

The ending of Prohibition in 1933 produced renewed interest in ethanol. The scarcity of oil during World War II caused a temporary rise in demand.

However, the evolution of ethanol into a significant global commodity really didn’t begin until the 1970s. Rising oil prices, embargoes and increasing dependence on foreign oil revived interest in ethanol in the United States. Since then, tax incentives and environmental regulations have steered oil companies toward creating cleaner burning fuels.

In 2005, the US Congress passed Renewable Fuel Standard (RFS). This law mandated fuel producers to use a minimum amount of renewable fuels including ethanol. In 2007, The Energy Independence and Security Act (EISA) raised the target of renewable fuel usage to 36 billion gallons by 2022. In 2020, fuel producers added about 14 billion gallons of ethanol to gasoline in the United States.

Today global ethanol production tops 25 billion gallons. However, the commodity is the subject of considerable controversy.

While proponents say it produces cleaner fuel and reduces dependence on fossil fuels, critics argue that ethanol produces its own pollution problems and does little more than subsidize the corn industry in the United States and the sugar industry in Brazil.

Why is Ethanol Blended?

Ethanol can be used on its own as a fuel, but it typically is blended with gasoline or diesel fuels. In the United States, gasoline contains about 10% ethanol by volume. There are both economic and scientific reasons for blending.

First, ethanol generally costs more to produce than gasoline. Although grain prices play a role in determining cost, alcohol production is also a significant cost. The distillation of grains is more complicated and costly than the distillation of crude oil.

Secondly, ethanol carries less energy than an equivalent amount of gasoline. As a result, it produces lower fuel efficiency than gasoline.

Finally, current automobile designs make ethanol more corrosive to engines. One reason for this is that ethanol absorbs more water from the air than gasoline, and this may contribute to contamination of fuel systems.

How Is Ethanol Produced?

Ethanol production begins with choosing a feedstock to make the fuel. Typically producers use the sugars in grains such as corn, sorghum and barley in the distillation process. However, other plants can also be used:

  • Sugarcane
  • Sugar beets
  • Potato skins
  • Rice
  • Yard clippings
  • Tree bark
  • Switchgrass

Production of these feedstocks into ethanol takes place mostly through fermentation:

Fermentation

The most common method of ethanol production uses yeast to convert the feedstocks into sugar. This process of chemically breaking down a substance into sugars is known as fermentation.

In the United States, the low price and abundance of corn makes it the most common feedstock used in the fermentation process. Wheat and sorghum are used to a lesser extent.

In other parts of the world, sugar cane and sugar beets serve as common feedstocks for ethanol production. In Brazil, which is the second largest ethanol producer after the United States, most production takes place with sugar cane.

Most modern ethanol plants are “dry grind” plants. In these facilities, machines pulverize corn kernels into fine particles. Water and enzymes are then added to the ground corn to begin breaking down the starch.

Fermentation Tanks – Image via Wikimedia

The mixture, which is called mash, then gets cooked in ovens and cooled down. At this point, a second enzyme, glucoamylase, gets added to the mash to help convert it into sugars. Finally, yeast is added, and the resulting fermentation creates ethanol and carbon dioxide.

After two days of fermentation, ovens heat the mash again. This heating releases ethanol in the form of a vapor, while the corn and yeast remain in a solid form. The ethanol vapor is collected, cooled and condensed into a liquid. Dehydration removes water from liquid ethanol and produces anhydrous ethanol. This substance can now be blended with gasoline.

Cellulosic Ethanol

A much less common form of ethanol production involves breaking down cellulose in plant fibers. This process, known as cellulosic ethanol, is more complex than fermentation.

In cellulosic ethanol trees, grasses and agricultural residues serve as feedstocks. These crops can grow on land not suitable for grain production and require less fertilizer, energy and water than grains do.

New strains of fast-growing trees can reach maturity in less than 10 years. As a result, cellulosic ethanol holds much promise for the future. However, current commercial production of cellulosic ethanol is very small.

After ethanol plants produce the fuel, trucks and railcars transport it to blending facilities where it is mixed with gasoline to form E-10 or E-85 blends used in consumer engines.

Railcars Transporting Ethanol – Image via Wikipedia

Unlike petroleum and natural gas, ethanol does not currently use pipelines for transportation. As a result, transportation costs impact the price of the product. Although the physical and chemical properties of biofuels make pipeline transportation more challenging, the industry is looking for ways to overcome these obstacles.

The United States and Brazil combine to produce about 85% of the world’s annual supply of ethanol.

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