Recent Farmdoc Daily articles explained how prices in short-crop years often peak early and decline throughout the remainder of the marketing year here, and then showed how farmers who insured using Revenue Protection (RP) insurance can use futures to protect insurance payments against a pre-harvest peak in crop prices here.
Options contracts can be used instead of futures contracts to hedge up to the TA APH yield times the coverage level. The earlier RP hedging article showed how the futures hedge “locked in” total revenue of $1,082/acre, regardless of whether prices moved higher or lower after the hedge was placed. However, there are some risks associated with this approach. If prices move higher after the hedge is established, the farmer would miss out on those higher prices and also might receive margin calls, all of which would leave him worse off than if he had not hedged at all. Maximum income would occur if prices happen to peak on the same day that the futures hedge is established. Readers should recall that the reason for hedging in this situation is to guard against a drop in prices prior to end of the RP settlement period in October.
Hedging with put options – the right but not the obligation to sell a futures contract at a fixed price at some later date – allows hedgers to maintain downside price protection while retaining the ability to take advantage of higher prices. This additional flexibility can allow hedgers to adjust hedges in response to changing market conditions. In addition, there are no margins and therefore no margin calls for buyers of options. Instead, the buyer pays a one-time premium at the time the option is purchased, and this premium is the most that the buyer can lose on the option position.
In this post we will present option hedges with two different outcomes at two different time horizons, using the same basic assumptions as before, to allow a side-by-side comparison of hedging with options and hedging with futures:
· RP crop insurance for corn has been purchased at an 80% coverage level
· The TA APH yield is 175 bu.
· The cash price in October will be 10¢ below the December futures price in October
· The October futures price will be the harvest price for the RP product
· Hedging will occur at 140 bu. (175 bu. TA APH yield x .80 coverage level)
· Actual yield will equal 100 bu.
· The current December futures price is $7.80
While there are many different “strike” or exercise prices that could be used, in these examples we will buy a December $7.80 (at-the-money) put option now and pay a premium of 62¢/bu. Based on the assumption that December futures are currently trading at $7.80, we will examine the outcomes if futures prices a month from now are $1/bu. lower ($6.80) or $1/bu. higher ($8.80), using an online option pricing tool to estimate option premiums. These are the same prices ($6.80, $7.80, $8.80) used in the earlier futures hedging examples, so we can directly compare the results from our option hedges to those earlier futures hedging results. In addition, two different time horizons are considered: late August (representing an early peak in prices for the marketing year) and late October (corresponding to the end of the RP settlement period).
At-the-money option premiums change by only about half as much as the underlying futures price (i.e., the delta is approximately 0.5), so a 10-cent change in the December futures price will cause the premium of our put option to change by about 5 cents per bushel. Therefore, we need to buy twice as many put options as the number of futures contracts we would have used for a futures hedge.