In early March, I had the good fortune to attend Commodity Classic in San Antonio. This show draws thousands of farmers from all corners of North America. It was three days of renewing old friendships and meeting new people – at the show and on the River Walk. It was great fun, and I recommend you join us in Anaheim next year.
I also used the time to sit in on several marketing-related programs. At one session that drew nearly 1,000 people, one of the four speakers noted the need to use put options when pricing new crop grain (the market might go higher and you must protect the upside!). Three heads nodded in agreement. I am seated in the back of the room and my head is shaking back and forth in disagreement. I think the time is right to outline my philosophy towards the use of pricing tools.
Pricing tools, in my mind, can be separated into three broad categories; fixed-price tools, minimum-price tools, and technical tools. Fixed-price tools include simple forward contracts, the sale of futures contracts, and hedge-to-arrive contracts. They involve little or no cost to establish a final price (or nearly establish, as basis is still to be determined with futures or an HTA). The problem? Use these tools and your “upside” potential is limited.
Minimum-price tools include the use of options. Two popular strategies include the purchase of put options and the combination of a forward contract and re-ownership with call options (a form of paper farming). In both cases, your upside potential is unlimited. The problem? High cost! As of early spring, an at-the-money December corn option costs nearly 30 cents/bu., while ATM November soybean options will cost nearly 60 cents/bu. Numbers like that make it difficult for me to use options to make early, lower margin sales.
Technical tools like moving averages, oscillators, and trend-lines cost nothing to follow but the pay-off and value as a risk management tool is anything but certain.
In general, I prefer to use simple, low-cost tools to price grain early in the execution of a pre-harvest marketing plan; forward contracts, futures contracts and hedge-to-arrive contracts. By early, I mean in the pricing of the first one-third of my crop. These early sales are, almost by definition, lower priced sales with thinner (if any) profit margins. If my expected margin is small, is this the time to spend 30 cents or more on an options strategy? I say no.
I like to save options and/or technical tools for the later stages of the plan – the middle third of the plan. Waiting has benefits. First, if the market is rallying and prices are higher, your margins are also higher and now you have the resources to cover those high options costs. Second, waiting can lower the cost of options, in particular the time-value component of the premium. Finally, technical tools work best when markets are trending, and waiting might get you into late spring or summer, a time when weather-driven trends are more likely to persist.
Let’s hope that the months ahead show us higher prices and the opportunity to consider a wider array of pricing tools.