Sometimes you need to spend money to make money. Wouldn't it be worth spending $18,000 to generate an additional $25,000-plus return from a 500-acre corn crop yielding 150 bu./acre? Of course. So why don't more growers spend some money buying put options to ensure a floor price three, four or even eight months prior to harvest?
There are various reasons why growers don't use futures or options offered by the Chicago Board of Trade (CBOT). Some have been burned on a hedge. Others have listened to too much coffee shop talk of bad trades. Others lack the knowledge about even the basic use of puts or calls. And some believe options are too expensive.
The CBOT works with many state Extension economists, lenders, grain handlers and commodity brokers and consultants to provide educational marketing seminars for growers and others.
“The CBOT currently hosts eight agricultural seminars ranging from a two-day introductory workshop that gives an overview of the cash markets to an advanced session that covers spread relationships and hedging,” says Ted Doukas, managing director responsible for educational opportunities for business development at the CBOT.
An important feature of options is flexibility, says Chris Hurt, Purdue University Extension economist. “You can manage your downside and the level at which you wish to set a price,” he says. “This flexibility is valuable in having the ability to establish a risk management program for individual situations.”
Still, many growers shy away from actually pulling the trigger on options trades. But growers should know that making options trades doesn't have to be rocket science.
If you can pocket an extra 30¢/bu. or more for your corn or $1/bu. for soybeans, why not look into simply using put options to set a floor price? It should let you sleep better. You can concentrate on your field operations and not worry about how far the market will drop today.
You've heard this before, but it's worth repeating — buying a put option on all or part of your corn crop is like buying insurance on your car or your home. You are protecting the value of your crop if the price drops by the time you sell it.
Call it price protection insurance, but with a put option in place, all you're out is the premium cost of that option. The premium will likely be 10-20¢/bu. for corn and 20-40¢/bu. for soybeans, depending on the risk level taken with an option.
That's not a small outlay, but still a bargain if you can lock in a price that is above the loan level.
As an example of using a put for price protection, consider the 500-acre corn grower who, when December 2005 corn futures topped $2.50 in June, bought the $2.50 put for a premium of 22¢/bu.
He paid roughly $16,500 in premiums. That breaks down to $1,100 for each 5,000-bu. put option contract (22¢ × 5,000).
With 75,000 bu. to cover, that means he locked in 15 contracts, again at a cost of $1,100 per contract, or $16,500 total, plus about $1,200 in brokerage commission fees. (Commissions vary and could be lower if e-trading or if a discount broker is used.)
That gave him a floor price of about $2.36, which includes the cost of the put contracts and commission. Compare that to the early harvest December futures price of about $2. That's a 36¢/bu. better price. And with a solid LDP of about 40¢/bu., or better than $30,000, the cost of the price protection is more than covered.
What about 500 acres of soybeans? In June and November 2005 soybean futures stretched above $7.50. A $7.20 November put option cost about 36¢/bu., or $1,800 per 5,000/bu. contract.
For an average yield of 50 bu./acre, that puts total production at 25,000 bu., which equals five put option contracts. At $1,800 per contract, the cost of the $7.20 put was about $9,000, plus about $400 in brokerage commission fees.
Consider that $7.20 strike price and the early harvest November futures price in the $5.80 range. That's an extra $1.40/bu., or $35,000 on the 25,000-bu. total yield.
Take away $9,400 for premiums and commission fees on the five put option contracts, and the grower gains more than $25,000 extra dollars. (There is likely no or little LDP for soybeans in these conditions.)
Call options offer a different method of managing price. Say you don't have storage for all the 2005 crop corn. On those bushels you could sell cash corn at $1.80, collect 40¢ of LDP generating $2.20, then buy call options for May or July, when prices historically see their strongest levels.
In mid-September, for example, a $2.50 July 2006 call option had a premium of 11¢/bu. Buying the call option for that premium would enable a grower to take advantage of any July futures price movement above $2.50. If July futures don't move higher you'd have $2.20 minus the 11¢ of premium for a $2.09 minimum price.
“The grower can sell the crop, collect the LDP, then have a call option in place to take advantage of upside movements in the market,” says Hurt.
He stresses that growers must manage their options trades, even if they are a simple put or call strategy. “Once a put option trade is on, the grower should monitor it to determine if he wants to leave it on (if prices go down) or take it off (if the price goes up),” he says.
One of the best sources for learning more about the use of futures options is your regional Extension economist. Local and regional commodity brokers and consultants are also good sources.
The CBOT offers online tutorials on options. Find them at www.cbot.com, which also opens the door to all types of agricultural commodity trading opportunities.
Know Your Options Terms
The CBOT has a glossary that reviews all of its futures and options trading terms. Here are some common terms that should help in better understanding using puts and calls.
At-the-money-option — an option for which the strike price equals, or is approximately equal, to the current market price of the underlying futures contract.
Call option — an option that gives the option buyer the right to buy (go “long”) the underlying futures contract at the strike price on or before the expiration date of the option.
Exercise — the action taken by the holder of a call if he wishes to purchase the underlying futures contract, or by the holder of a put if he wishes to sell the underlying futures contract
Expiration date — the last day an option can be exercised. Options expire the third week of the month preceding the futures contract delivery month. For example, September corn options expire in August and November soybean options expire in October.
Futures contract — a contract traded on a futures exchange for the delivery of a specified commodity at a future time. The contact specifies the item to be delivered and the terms and conditions of delivery.
In-the-money options — a call is in the money if its strike price is below the current price of the underlying futures contract (for example, if the option has intrinsic value). A put option is in the money if its strike price is above the current price of the underlying futures contract (for example, if the option has intrinsic value).
Intrinsic value — the dollar amount that would be realized if the option were to be exercised immediately (see in-the-money option).
Margin — in commodities, an amount of money deposited to ensure fulfillment of the contract at a future date. Buyers of options do not post margins, since their risk is limited to the option premium, which is paid in its entirety when the option is purchased. However, option sellers must post and maintain margins.
Offset — taking a second option position equal and opposite to the initial or opening position, “close out.”
Open interest — the number of futures or option contracts of a given commodity that have not been offset, delivered against, exercised or expired.
Option — within the futures industry, a contract that conveys the right, but not the obligation, to buy or sell a futures contract at a certain price for a limited time.
Out-of-the-money option — a put or call option that currently has no intrinsic value. That is, a call whose strike price is above the current futures contract price, or a put whose strike price is below the current strike price.
Premium — the price of an option that equals the option's intrinsic value plus its time value.
Put option — an option that gives the option buyer the right to sell (go “short”) the underlying futures contract or the strike price on or below the expiration date of the option.
Strike price (or exercise price) — the price at which the holder of a call (put) may choose to exercise his or her right to purchase (sell) the underlying futures contract.
Time value — the amount by which an option's premium exceeds the options intrinsic value. If an option has no intrinsic value, its premium is entirely time value. Also referred to as extrinsic value.
Underlying futures contract — the specific futures contract that may be bought or sold by the exercise of an option.
Volume — the number of purchases or sales of a given futures or option contract made during a specified period of time.