You want to insure against a wreck in grain prices. But you may not want to be locked into straight futures or cash forward contracts, or pay the high price of a put-option premium. An options spread, or “fence,” may be the answer.
An options spread is a hedging strategy that effectively creates a floor price and a ceiling price. Here’s how it would work. Assume you’re a soybean grower who's already planted. The November 2012 soybean futures contract is trading at $12/bu. and you anticipate your local basis to be about 30¢ under.
You like the idea of having downside price protection against a harvest-time seasonal price drop. But if there’s a market rally between now and the fall, you may not be able to take advantage of it if you buy a straight futures contract or establish a cash forward contract.
Instead, you buy a put option. You have downside protection, but are not locked in if prices rise. The catch is that options premiums are higher than what you’d like to spend. However, you can sell an out-of-the-money call option to cut that cost of protection.
Darrel Good, University of Illinois Extension economist, says the spread would help cheapen the cost of price protection, but “there’s no right answer” to how wide a spread you establish.
Here’s an example of a put/call spread, using a $12 November put and a $14 November call. That spread would provide a $2 pricing window in the event of a rally, while establishing floor and ceiling prices.
November 2012 $12 soybean put options recently had a cost of about 95¢/bu. That’s nearly $5,000 for one 5,000-bu. contract – too high a price for many growers.
But at the same time, you could sell the $14 November call for about 40¢/bu., or about $2,000/contract. That lowers the cost of price protection to about 55¢/bu., or $2,750.
With the 30¢ under basis and 55¢/bu. cost of price protection, the grower has an overall floor price of $11.15 ( $12 - 85¢). The ceiling is $14 for the number of bushels covered in the spread, less the basis.
If the bean futures market slides to below $12, you’re protected. If it goes up to $14, you can still benefit from the rally. Again, those price levels are examples, and market prices and premiums can change by the minute, so double check the quotes before establishing a spread.
When considering use of an options spread, Good recommends that growers first look at USDA’s Risk Management Agency revenue protection insurance. “You start by thinking about how a spread strategy might fit into your overall marketing plan,” he says, “particularly if you have revenue protection.
“Revenue protection can cover up to about 85% of projected production. Growers can think of that as having a put option in place, with the price and cost depending on the level of protection selected. The question then is, if the price moves above that insurance price, how can you use options to protect the higher price and keep the upside open.”
For example, he says, if the soybean revenue guarantee price is $12 through RMA and the futures price goes to $13, a grower may want to secure that price level. An options spread could help him hold down the cost of buying a put. “You then have to determine the put/call spread to make sure there is enough upside potential without placing the cost of the put option out of reach,” Good says.
“If you sell a call with a high strike price, you have a higher upside, but you may not collect enough premium to lower the cost of the put. Conversely, if you sell a call at a lower strike price, you can collect more premium to lower the cost of protection, but you have a smaller upside potential. You have to consider the tradeoff that will result in an options spread strategy.”