Agricultural trade options are tools for managing agricultural price risk exposure. They are referred to as “trade options” because, unlike exchange-traded options, which are bought and sold on a designated contract market, agricultural trade options are bought and sold off-exchange directly between commercial market participants for business-related purposes.
Apart from their “over-the-counter” feature, agricultural trade options are similar in most respects to exchange-traded options. They permit the purchaser to buy or sell an agricultural commodity at a pre-specified price called the “strike price” on or before a given “expiration date.”
An option to buy is referred to as a “call” and an option to sell is known as a “put.” The purchaser of an agricultural trade option pays a “premium” for the right (without the obligation) to buy or sell the underlying commodity at the strike price and this premium represents the maximum loss that can be incurred by the option buyer. In return for this premium, the option seller, or “writer,” is exposed to potentially unlimited losses.
An agricultural trade option may be “exercised” by the purchaser by making (in the case of a put) or taking (in the case of a call) delivery of the underlying commodity or by means of a cash payment. In general, options are only exercised when they are “in-the-money”—this occurs for a call when the strike price is below the current market price and for a put when the strike price is above the current market price. For exercise to be profitable, the amount by which an option is in-the-money must exceed the premium paid for the option. When an option’s strike price is equal to the current market price, the option is said to be “at-the-money.” When a call (put) option’s strike price is above (below) the current market price, the option is said to be “out-of-the-money.”
Part 32 of the CFTC’s regulations, 17 CFR 32, governs the sale of commodity options in the cash market. CFTC Regulation 32.4 largely exempts from Commission oversight “trade options,” that is, cash market options entered into by commercials for business-related purposes. The exemption applies to all commodities other than the “enumerated” agricultural commodities 1. Options in the soft commodities (coffee, sugar, and cocoa), dairy products, and lumber qualify for the trade option exemption. The trade option exemption applies to all commercial entities, regardless of size.
Trade options in the enumerated agricultural commodities are subject to a separate exemption under CFTC Regulation 32.13. Under this exemption, options may only be offered or purchased through a registered agricultural trade options merchant (ATOM), and may only be transacted between commercial firms for business-related purposes. However, commercial firms with a net worth of $10 million or greater are exempt from the agricultural trade options regulations, and are treated essentially the same as if they fell under the more general trade options exemption.
How to Become an Agricultural Trade Option Merchant
In June 1998, the CFTC began a program to permit the purchase and sale of agricultural trade options in the enumerated commodities. In December 1999, the Commission amended the program to streamline the registration process and to provide greater flexibility in option contract design by allowing cash settlement of contracts.
An entity that plans on offering or selling agricultural trade options as part of its agricultural business, may do so only in compliance with the program rules. Before offering or selling agricultural trade option contracts, an entity is required to register as an agricultural trade option merchant (ATOM).
- registration of ATOMs,
- financial requirements,
- conditions on contracts and on their offer and sale, and
- disclosure and reporting requirements.
An entity is only eligible to solicit, offer, or sell agricultural trade options if it operates in commercial agricultural markets and if it has registered with the Commission as an ATOM. In addition, its sales representatives and their supervisors, as well as its principals, must register as associated persons (APs).
To apply for registration as an ATOM, an entity must contact the National Futures Association (NFA) which processes registrations on behalf of the CFTC. Registration forms for ATOMs, their principals, and their APs are available by telephone from the NFA at 800-621-3570. Completed registration forms should be returned to the NFA, Office of the Secretary, P.O. Box 98383, Chicago, IL 60693-0001. For further information, or to download a registration form, you may go to the NFA’s website.
Registration lasts for an indefinite period.
Applicants for ATOM registration must maintain a net worth of $50,000 at all times. The registration application must include the ATOM's most recent annual financial statement audited by a certified public accountant (CPA) during the previous 12 months.
A number of grounds exist that disqualify ATOMs, their principals or their APs from registering. For example, a potential registrant must not have had a prior registration revoked or been convicted of or enjoined from violating laws as specified in the program rules. APs may not have had a prior registration revoked or been convicted of violating laws relating to futures or securities trading, embezzlement, theft, fraud, or similar types of wrongdoing.
All agricultural trade option contracts must be in writing or, if verbal, must be confirmed in writing. If an entity decides to offer or sell an agricultural trade option, it must give its customer a signed copy of the written contract. The option contract confirmation must include all terms and conditions of the contract.
Before entering into an agricultural trade option, the CFTC requires that an ATOM disclose to its customer information about the general risks of agricultural trade options. Disclosures can be printed or electronic.
An ATOM must also provide its customers with:
- a written confirmation of each agricultural trade option contract;
- information that the customer requests about commodity prices, or the customer's positions or funds; and
- notice that an option will expire within the coming month.
In addition to the requirement to maintain at least $50,000 in net worth, an ATOM must also segregate funds that its customer pays up front (the option premium), in a separate bank account. However, it may use its customer's funds to hedge or cover the trade option with an exchange-traded option on a designated futures exchange. In addition, the ATOM must have a written policy governing internal trading and supervisory controls as well as an annual financial audit.
An ATOM must keep full and complete books and records for five years, and during the first two years, they must be readily accessible for inspection.
ATOMs are also required to report to the Commission annually on volume, open interest, and the total amount of commodities underlying the options they sell.
If a dispute should arise regarding the terms of an option contract and an ATOM and its customer are unable to resolve it, the customer may file a reparations claim with the CFTC. To file such a claim, the customer must show that one or more of the provisions of the Commodity Exchange Act or the CFTC’s rules was violated, thereby causing the customer to suffer a loss on the agricultural trade option. The ATOM and its customer can also agree to any other dispute resolution forum provided in the contract, such as arbitration, and either party may also be able to bring the dispute to court. However, an ATOM’s contract may not impose a binding pre-dispute arbitration requirement on a customer. A dispute arising solely out of a cash market transaction would not be eligible for the CFTC Reparations program.
The CFTC Glossary provides definitions of technical terms used here.
1 The enumerated commodities are listed in Section 1a(4) of the Commodity Exchange Act, 7 USC 1a(4), and CFTC Regulation 32.2. They include wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice.