Benjamin Franklin coined the phrase “a penny saved is a penny earned.” Ed Usset, on the other hand, thinks farmers should pinch their pennies a dime at a time.
Usset, an educator with the Center for Farm Financial Management at the University of Minnesota, says options are the most costly component of a farmer's marketing plan. He says farmers can hold onto their dimes if they market smart and stay disciplined.
“I'll hear some broker say you can protect yourself for just 10¢. My response is ‘Just 10¢!’ I know options pay off sometimes, but that's a lot of money to me,” says Usset. “I want to keep my dime.”
A former trader on the floor of the Minneapolis Grain Exchange, Usset says he remains “wholly unimpressed” with options, especially for farmers.
“If options are such a great pricing alternative,” Usset says, “Then why have I met so few producers who have had a profitable experience with them?”
Usset says the problem with options is three-pronged: they cost too much, they're too complex and farmers lose focus when using them.
As for cost, by not spending that 10¢ more per bushel, the average producer could move into the top third of marketers, Usset says. And, he points out, 10¢ is a conservative cost estimate for options. “Most at-the-money soybean options have been 50¢ or more this year,” he says.
“Producers should eliminate mistakes,” Usset says. “A lot of farmers produce 100,000 bu. of corn. Saving 10¢/bu. is $10,000. At $2.50 corn, that's like finding another 8 bu./acre on 500 acres.” Eliminating marketing mistakes should be easier than growing an extra 8 bu./acre, he adds.
Usset realizes it's possible to make money on options, but says most farmers don't want a complicated marketing plan.
“To make money using options you have to have a trader's approach to them. Most farmers don't, and they don't want to,” he adds.
Options can complicate marketing, Usset says. The very thing that could make them a good tool makes them dangerous — their flexibility.
“There are a hundred ways to slice and dice options strategies,” says Usset. “The real danger comes when farmers lose focus. I've seen farmers so wrapped up in their options strategy they weren't sure if they wanted the market to go up or down.”
Not everyone agrees with Usset's “no options” idea, however.
Robert Wisner, an ag economist at Iowa State University, says the market doesn't always move the way you want. That's when a preharvest options strategy can come in handy.
“One of the biggest factors holding farmers back from aggressive preharvest pricing is fear that prices might go higher after they've sold their crop,” he says.
Options can provide more confidence for preharvest marketing by retaining upward price flexibility Wisner says. But farmers must use options carefully to capture potential benefits.
More than 70% of options for both corn and soybeans expire worthless each year, according to Alan Kluis at Northstar Commodities, St. Paul, MN. He says many farmers are comfortable buying both puts and calls, noting that selling options is where the difference lies.
“I'd say that four times more farmers are buying options than selling them,” says Kluis.
“Over the last 30 years, December corn futures have followed a pattern that by mid-September would increase the value of put options purchased at planting time about ¾ of the time,” Wisner says, “even though options have only been available ⅔ of those years.”
He points out that at the same time, puts — unlike forward contracts for harvest delivery — leave flexibility to store corn so you can take advantage of years like 2003-04 when prices rose strongly after harvest.
“The other ¼ of the years, the puts become worthless by harvest-time, but would be offset by sharply higher prices,” says Wisner.
“Over the long run, forward contracts will do better than put options for farmers who can emotionally and financially handle the occasional years when prices rise after they've locked in prices,” he says. But properly used puts over the last 20 years have performed better than strictly cash sales.
Wisner says the track record for soybean puts is less favorable than for corn, although some years of high spring prices have offered profitable opportunities. He also points out that call options purchased in the spring and held until fall, in contrast to puts, would lose money about ¾ of the time.
That's where a option fence strategy can be useful, says Wisner. A fence is buying a put option and selling a call option at a higher strike price.
The difference between the two strike prices is the spread your options fence is straddling. Any profit higher than your call strike price is offset by a loss from your put option.
Essentially, you've set both a ceiling and a floor for your profits, but the cost of your put option will be partially offset by the premium gained from selling a call option. Your upside is limited, but is greater than a forward contract, says Wisner. And your cost is less than a straight option purchase.
“This tool should be used conservatively,” says Wisner. “You don't want to risk over-selling your crop when you have an unknown loss risk on sold calls and you don't have the physical corn to offset the losses.”
Brad Glenn, a Stanford, IL, farmer, sometimes uses a fence strategy. “Typically, I like to have a larger percentage of my crop forward priced earlier in the year and then employ an options strategy on the remainder,” he says. “In a downtrending market that strategy has worked well for me.”
Usset agrees that an option fence is a good way not to give up a whole dime/bu., but says farmers really have to pencil out the cost to see if it's worth it. He still favors a sound forward-pricing strategy and keeping the dime. (See chart below to calculate the minimum and maximum prices by using options.)
Glenn favors early forward contracting but prefers to keep his options open, especially using puts to set a pricing floor.
“A put defines my downside risk,” says Glenn. “It's scarier not to know what my floor is than not to know what my potential profit is.”
Glenn says he calculates the cost of options into his operating costs. If prices aren't favorable, he knows options are one way he'll feel comfortable enough to pull the trigger.
“No one would ever use options if they could pick the market top,” says Glenn. “That dime might not get me in the top third of marketers but it may keep me out of the bottom third.”
| $2.50 | Put Strike Price |
| - 0.12 | Premium Paid (For $2.50 Dec. Put) |
| - 0.01 | Brokerage Fee |
| - 0.35 | Expected Harvest Basis |
| $2.02 | Minimum Price or ‘Floor’ |
| $2.50 | Put Strike Price |
| -0.07 | Net Premium for Options* |
| -0.02 | Brokerage Fees |
| -0.35 | Expected Harvest Basis |
| 2.06 | Minimum Price |
| $2.06 | Minimum Price |
| +0.50 | Spread Between Put And Call Strike Prices |
| $2.56 | Maximum Price or ‘Ceiling’ |
| $0.12 | Price of Bought Option (For $2.50 Dec. Put) |
| - 0.05 | Sold Option Premium (For $3.00 Dec. Call) |
| - 0.07 | Net Premium For Options |
SOURCE: ED USSET, CENTER FOR FARM FINANCIAL MANAGEMENT, UNIVERSITY OF MINNESOTA