I just sold my grain and then the market went up!!!! GRRRRR!!!!
Has that ever happened to you? Many farmers use minimum grain market pricing strategies such as futures contracts, forward contracts, and hedge-to-arrive contracts to set prices for their commodities. But what happens when we do the right thing and lock in profit; and then the market makes a bullish move up? Well, a marketing tool known as Options can help capture that upside.
What are Futures Options and how can I use them?
Futures options are the option to buy (a call option) or the option to sell (a put option) an underlying futures instrument for a given period of time at a specific price.
What are “put” and “call” options?
- Put options are the right to sell one futures contract at a given price for a certain period of time.
- Call options are the right to buy one futures contract at a given price for a certain period of time.
All options are bought and sold for a price called a premium. The premium is determined by several factors as follows:
- Time – the longer the time duration the higher the price. The writer of the option demands a higher premium because the probability is higher that the option will become profitable (in the money) given the longer time duration
- Strike Price – the strike price is the price at which the option will become profitable (in the money). Option prices are adjusted based on the difference between the options’s strike price and the underlying futures contract it’s derived from
- Volatility – the greater price fluctuations in the market create higher risk to the options seller; therefore, the higher the price. For example, if corn just limited down two days in a row then the price of the options for corn are going to be extremely high
- Supply and Demand – all markets consist of buyers and sellers. The difference between the number of people interested in selling the options as opposed to those interested in buying the options also has a great effect on price.
What are some basic strategies farmers can use to hedge their crops?
- Buying a put option. When you buy a put option, you are agreeing to sell the futures contract at whatever strike price you chose as well as whatever expiration date you chose. This will hedge you against a dramatic down move in that futures contract. Assuming you are still holding the commodity in your field or in your bins, you will be able to capture the upside if the market moves up deducting the premium you paid for that contract. It’s like an insurance policy; just because you own a fire policy on your house, you aren’t hoping it will burn down. You want the price to increase more than your premium so you can expand on your profits but can sleep at night because you know if the market decides to fall off a cliff, you are protected.
- Buying your crop back with a call option after you have made a forward contract. Your forward contract set the minimum price for your grain, but the market may still go up. This is where re-owning your grain with a call option may come in handy. The call option gives you the ability to capture more profit in a bull market if the market has moved above your strike price (plus your premium paid for the call option).
There are countless other ways to use options but the two above are the most popular hedging tactics. Many of the other option strategies such as selling calls and puts would be considered very speculative and can also be considered “weapons of farmer destruction” if used incorrectly. The two strategies above allow insurance for a given period of time should the market quickly get away from you.
Lets try a few examples:
The following image is the futures options quotes for December 2015 corn, next year’s harvest:
Lets analyze each strategy for this snapshot in time:
- Buying a 450 DEC 15 PUT – the last price was 58.75 (0.5875 in cash terms). That will give you 4.5 – 0.5875 = 3.9125 as a futures price. Now to convert that to cash, deduct your expected harvest basis and the brokerage charge for that. 3.9125 – 0.85 – 0.01 = 3.0525, that’s your final cash price not including the normal shrink, dockage, and moisture discounts. If corn goes below 3.0525 you’re a genius. You would also be able to capture any gains above your options costs (premium + brokerage fee) 0.5875 + 0.01 = 0.5885. This is saying a couple of different things:
- You’re hoping the price of corn goes up more than 0.5885. Many supply and demand imbalances can cause this.
- You’re insuring against a price below3.0525 assuming the basis is 0.85 at harvest. This can also happen however your insured against it.
- Forward contracting your grain at 4.20 futures 0.85 basis for a cash price of 3.35 and buying a 420 DEC 15 CALL – you locked in your minimum price at 3.35, but you want to capitalize on a drought or some unknown factor that may drive these markets back up to 8.00. You buy the call for 36.75 (0.3675). Total costs of the premium plus the 0.01 brokerage are 0.3775. Deduct that from your 3.35 to get a new minimum price of 2.9725. This is a little lower than the put in the earlier example, but you will receive upside faster with the call.
- Your call position will give you a minimum price of 2.9725 and will let you run with the bull market above 4.5775.
- Your put will give you a minimum price of 3.0525 and let you join the bulls at (current futures price (4.21) + premium and broker fee (.5885) = 4.7985.
- The minimum price is lower by owning the call but you can get back in the race, if there is one, much sooner than you could by owning the put.
That was pretty interesting! Options can tell you what direction the market is expected to move based on the analysis we just did. We have a spreadsheet that will simplify this calculation if you just put in your prices and basis.
Thanks so much for reading about Futures Options! I hope the information was helpful and can be used as a tool in maximizing the profits on your farming operation! Good luck in the Grain Markets!
For more resources please have a a look at:
- Marketing Specialist at the University of Minnesota Ed Usset’s Blog
- Test out your Commodities Trading with the Commodity Challenge developed by Ed Usset
- FINBIN – great for farm financial data and production numbers
- How to determine if commodity prices are too low to market grain