Session 1, Lesson 11 / OTHER USES OF OPTIONS
In our last lesson we looked at the use of call options as part of a replacement hedge strategy. As a refresher, you’ll recall that this strategy entails selling your crop and repurchasing that production with call options. The main idea behind that strategy is to reduce the downside price risk and exposure which you would have by storing that grain, and also free up the cash while still leaving open the opportunity to benefit from a future price rise. While this is a very common use of options, others are certainly available that we’ll look at in this lesson.
Another common strategy is the purchase of call options to cover grain which is forward contracted. An example of this strategy would be the trader who, during the spring of the year, decides to forward contract some of his grain. If a trader decided to forward contract 25% of his expected production at a certain price in spring, assuming that we have a normal crop year, prices could be substantially lower by the fall. The trader could find that those forward contracts were a very wise decision at that time. While that would certainly be the case in a normal crop year, there is never exact certainty in spring, and it is very possible that much price volatility lies ahead. Seasonally market direction should be higher into June or July and a trader forward contracting too soon might miss out on those increases.
Another situation in which calls can be utilized is when there is bad weather which sharply reduces yields and results in substantially higher prices. Without the protection of call options, not only is the trader missing out on marketing at higher prices, but his yield may be cut enough to put his ability to deliver on his forward contracts at risk. Call options provide an opportunity to help manage that risk. Lets look at an example.
In the first case, a trader forward contracts some corn this month at a price of $2.50 a bushel. At the same time, he buys a July call option with a strike price of $2.50 for approximately 10 cents. (We’ve selected a July option because the trader is primarily concerned with his risk through planting and into the early part of summer.) He has decided that if he is still concerned about the risk of this production beyond late June, he can select an option with a more deferred contract month and cover that corn at that time.
Once the trader has the corn forward contracted and the call options purchased, the market can do basically three things. If prices go down from that point on, the trader has the corn forward contracted and would receive $2.50 on his local cash market when he delivers it in fall. His option would be of no value and he would have to write off the cost like he would any other type of insurance which he failed to collect on. The fact that he did not collect any money on that option does not make it a bad investment. The purchase of that call option gave him a certain amount of risk protection. The real question becomes, is that protection necessary based on that trader’s financial condition and ability to handle risk? Only you as an operator can answer that question for your operation.
The second price scenario is where the market remains basically unchanged. In that scenario, the trader simply delivers his grain at the agreed upon price and the option would have no value. Here also, we’ve had the protection as well as the expense of the option.
The third alternative would be for prices to go higher. If prices go higher, temporarily the trader may be able to benefit and end up with a higher net realized selling price for his crop by cashing in his option at some future date. Let’s say for example that prices follow a seasonal pattern and work higher into May or June. In that case, the call option that the trader purchased would become worth more than his original purchase price. For the sake of our example, let’s say that this option becomes worth 20 cents and the trader decides to cash it in. Subtracting his 10 cent cost to enter the position, he is left with a profit of approximately 10 cents. That 10 cents could then be added to the forward contract price of $2.50, giving the trader a net realized price of $2.60 per bushel for his corn. If the price of corn continued to rally after the trader cashed in his option, he would be foregoing that additional revenue, however.
Let’s say that we have a worst case scenario where the trader is unable to get his crop planted in spring and prices go substantially higher throughout the country. In this case, the option can literally be a lifesaver for that trading operation. By owning the call option, the trader would have the right to purchase corn at the strike price of $2.50 and ultimately could fulfill his forward contract. At this point the example becomes over-simplified because there are many other costs to consider, but the basic concept is that the trader has some protection in case of a major disaster.
I want to again stress the aspect of options as insurance, especially with the idea of protecting against a major disaster. You don’t buy health insurance to cover the cost of buying a bandage or vitamins. To do so would be impractical, yet some people view options to that degree. They feel an option needs to cover every small price move. That’s really a misapplication. You buy health insurance to protect you against the big losses — the major medical expenses and situations that could devastate you financially. Options should play the same role in your operation. They should be used to help you manage the risk and avoid catastrophic losses of income. Yes, there is a cost to providing that protection. The question becomes, are you better off paying the cost of that insurance and providing a certain level of income stability, or are you better off taking the risk and riding out the rough times? There have certainly been enough market corrections over the last 10 years to help demonstrate what could happen to those who make the wrong choice.
Again, options are not for everyone, but as a good marketer it’s important to weigh the options or alternatives, pencil it out and make the right choice.
Another common use of call options this time of year is to help hedge deficiency payments. While some years this is more important than others, it is still worth considering. In simplest terms, call options are purchased to protect yourself in case your deficiency payment declines. Many traders early in the year, as they’re working with their lenders, do certain cash flow projections based on selling their crop at a certain price and receiving a certain amount of government deficiency payments or other inputs. If crop prices rise and you’ve already locked in your corn with a forward contract, you could be faced with a situation where you’re meeting your budget projections for the sale of your crop, but coming up short because your deficiency payment has been reduced and you have no other source to offset that loss of income.
Purchasing call options can help in that situation because as the market rises and the deficiency payment is reduced, the call option would increase in value and ideally offset that amount. This type of strategy requires careful calculation, but again is very helpful in long range planning and in dealing with your lender. It’s these types of strategies which can really demonstrate to your lender that you’re on top of the marketing game and a very good credit risk.
ANSWERS TO LESSON 10 ASSIGNMENT
1. In the example of prices being down, what would the net realized selling price be assuming a cash sale date of June 15 and a price of $2.00?
$1.80 ($2.00 – .20 interest) for storing.
2. In the example where prices went down and you used the option, what would have been your net realized selling price if cash corn would have been $2.00 on June 15?
$2.30 for selling October 15 and buying options.
3. In the example where prices increased, which would have been the better alternative if prices had gone to $3.00? $3.25?
In both cases the net realized selling price would be the same. Which is better is then determined by other cost and risk factors unique to each operation.
4. Which example using the numbers given in our problem would have yielded the best realized selling price on June 15 had the cash market not moved and basis remained the same?
Selling cash on October 15 and not buying would have yielded the highest return for the trader.
— The farmer hedger will normally be a buyer of call options, which can be used for a variety of strategies. Purchasing call options in grain against a crop which has been forward contracted can help protect against unexpected price swings.– Call options can also be purchased against grain that has been forward contracted to hedge against the loss of deficiency payments.– Feed inputs can also be hedged using call options, especially in the case of corn and soybean meal. — Livestock producers, in addition to using call options to hedge feed needs, can be using calls to lock in buying price for feeder cattle and through a cross hedge feeder pigs.