If you are bearish on ethanol, you can profit from a fall in ethanol price by buying (going long) ethanol put options.
You observed that the near-month CME Ethanol futures contract is trading at the price of USD 1.5800 per gallon. A CME Ethanol put option with the same expiration month and a nearby strike price of USD 1.6000 is being priced at USD 0.1100/gal. Since each underlying CME Ethanol futures contract represents 29,000 gallons of ethanol, the premium you need to pay to own the put option is USD 3,190.
Assuming that by option expiration day, the price of the underlying ethanol futures has fallen by 15% and is now trading at USD 1.3430 per gallon. At this price, your put option is now in the money.
By exercising your put option now, you get to assume a short position in the underlying ethanol futures at the strike price of USD 1.6000. In other words, it also means that you get to sell 29,000 gallons of ethanol at USD 1.6000/gal on delivery day.
To take profit, you enter an offsetting long futures position in one contract of the underlying ethanol futures at the market price of USD 1.3430 per gallon, resulting in a gain of USD 0.2570/gal. Since each CME Ethanol put option covers 29,000 gallons of ethanol, gain from the long put position is USD 7,453. Deducting the initial premium of USD 3,190 you paid to purchase the put option, your net profit from the long put strategy will come to USD 4,263.
|Long Ethanol Put Option Strategy|
|Gain from Option Exercise||=||(Option Strike Price - Market Price of Underlying Futures) x Contract Size|
|=||(USD 1.6000/gal - USD 1.3430/gal) x 29000 gal|
|Investment||=||Initial Premium Paid|
|Net Profit||=||Gain from Option Exercise - Investment|
|=||USD 7,453 - USD 3,190|
|Return on Investment||=||134%|
In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.
In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the ethanol option sale will be equal to it's intrinsic value.
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