Here’s the situation: You’re bullish corn and soybeans and storing most of your 2011 crops to wait for a rally into early spring. But with huge price volatility, you consider using put options to protect against an unexpected drop in prices. But do you want to spend the money?
Put options, by nature, are insurance policies against a drop in prices. And as everyone knows, insurance premiums, whether for a pickup, combine or home, can be expensive. Your hope is that you never have to collect on such insurance policies, says Ed Usset, University of Minnesota Extension grain marketing specialist.
“You should consider using puts when you’re so bullish that you can’t see straight,” Usset says. “You have to have a sense that prices have considerable upside potential. The put provides insurance if you’re flat out wrong about a bull market.”
So what about insuring your crop prices? For instance, would you be willing to spend about $2,000 to guarantee about a $6.30 March corn futures floor price? What about $2,700 to guarantee a $12.40 March soybean futures price?
The $2,000 is the approximate cost of one at-the-money $6.30 Chicago Board of Trade (CBOT) March corn put option, based on a 40¢/bu. premium (using mid-fall futures prices). The $2,750 is cost of one at-the-money $12.40 CBOT March soybean put, based on a 55¢/bu. premium charge.
If your corn averages 150 bu./acre, one 5,000-bu. contract covers the $6.30 price for nearly 35 acres. For a farm that averages 50 bu./acre for soybeans, the $12.40 price covers 100 acres.
All this breaks down to a cost of about $60/acre for corn (150 x 40¢) and about $27.50/acre for soybeans (50 x 55¢) – and whether you’re willing to pay those premiums to lock in a floor price in the age of volatility.
Unlike straight futures hedges, you’d be open to the upside if prices were higher when you sold your grain. If prices were below the $6.30 or $12.40 range minus the premium charges, you’d be price protected.
“Options cost so much,” Usset says. “If a $6 July put costs 60¢/bu. that’s expensive,” he says. “If I’m trying to add 25-30¢ to my price, an option that costs 60¢ is already on my wrong side.”
Here’s an exampleof how an at-the-money put may work. Say March corn futures increase from $6.30 to $7.30, an increase not uncommon these days. In such case, the put would expire worthless, although there may be some time value available.
Your goal is to sell at a higher level anyway, so the stated 40¢ put cost would be covered by the price increase. But in an opposite movement, you’re price protected.
Remember, volatile markets can cause futures prices to swing 50¢ or more a day, so keep a close eye on prices.
If oil prices take a 20% dive and pull corn futures down to $5 – something else that’s very possible – you can exercise the $6.30 put and be protected against the price drop.
In each case, the local basis will impact the final price. If the basis is 40¢ under, then the put floor price will be $6.30, minus the 40¢ premium, minus the 40¢ basis. Your price is $5.50, compared to $4.60 ($5 futures less the 40¢ under basis) if the put was not in place.
Along with being bullish corn or beans, Usset sees occasions where growers should consider using puts. Out-of-the-money puts, or those with strike prices below the futures price, normally have a lower premium, but provide less risk protection. There are also numerous strategies in using put and call options spreads to manage risk.
Usset encourages growers to use some sort of risk management to offset price volatility. And that may also include Risk Management Agency revenue-protection (RP) insurance, whichnormally cost less than options. “But options lovers will argue that even if options cost more, you can get in and out of options positions.”