Many farmers could increase their profitability by using options in a less conventional way. That's the view of Richard Brock, president and CEO of Brock Associates, a Milwaukee marketing advisory service.
Brock sees most producers buying put options to try and lock in price protection, which is all right, but too expensive. A more economical method is to sell two call options for every put option growers buy.
Here's an example that illustrates what he's talking about. On December 21, the premium on a $3.70/bu. December '07 corn put option cost 41¢. Thus December futures, which were $3.70/bu., would have to drop to $3.29/bu. for the producer to break even. “If growers only buy puts and calls, they have an 85% chance of losing, but that's what most growers are doing,” Brock says.
But if, in this example, growers sold two call options at $4.30/bu. for 24¢ each, the grower would actually pocket 7¢/bu. (less commission cost). “He would thus have put a floor in of $3.77/bu. and a ceiling of $4.54. “If I just buy a put, I only have locked in a floor of $3.29.”
Why don't more growers follow this strategy? University of Illinois economist Darrel Good says that, although strategies such as what Brock mentions can reduce their cost, “the risk is also increased since selling two call options against one put option means that money will be lost twice as fast as it is made if prices exceed the call option strike price.”
Joe Sanger, a corn and soybean grower in southwest Kentucky and northwest Tennessee, uses options most years to lock in a price floor of $2.50/bu. Last year, for example, he bought a $2.50 put early in the year and sold $3/bu. calls, so his net premium cost “was zero or might be a few cents” per contract.
In each of the past four years, he's generally used options to protect about half of his crop. “Yes,” he adds, “I have the $2.50 floor, but that's not what I plan on marketing my corn for. That's just protection until something better comes along.”
Sanger adds that this year he will raise his target by $1/bu. The potential of corn rising above $4 and staying there is not very high.” However, Sanger says that with the growth of ethanol plant needs, the $4 mark could be hit.”
Good also says that the higher the strike price, such as $3.80-4/bu., the less risk there is that market prices will exceed call option strike prices. Good says that “if you're quick on your feet, you can get out of the call options when prices are going up, although you'll pay more than you sold them for.”
One problem Good has observed with options is that “producers get complacent and hold off marketing grain because they get too comfortable with the price insurance and don't react to price changes. Options are nice, but at some point you have to decide when to sell the corn.”