Session 1, Lesson 9 / PUT STRATEGIES

In our last lesson we looked at the strategy of buying put options to hedge a Stocks portfolio  that was currently exposed. The strategy we’ll look at today will deal with protecting the price of grain that a farmer has in storage.

Many farmers are influenced in their marketing decisions based on the tax consequences. Many are reluctant to sell the fall harvest until after January 1. This forces them into a position of storing grain until that point, leaving them open to further market fluctuations. When a farmer puts corn in the bin at harvest, you can normally anticipate basis levels improving, but you are still open to large swings in market prices. Prices could simply deteriorate into the end of the year or make a swing higher. Unfortunately, you’re never sure which it’s going to be. The use of put options allows you to establish a minimum price for that grain without limiting your upside potential. Let’s take a look at an example and see how the put option works regardless of market direction.

Lets start our assumption with the idea that you’ve just put your corn into the bin in October. To keep our example simple, we’re going to assume that the cash price and March futures are at the same level. In effect there is no basis between the two. You would need to adjust these figures based on your local situation. Lets say in October that the cash price is down to $2.00 and March futures are also at that same level. Assuming that basis does not change, you’ll remain completely exposed to any price changes which may occur. Say that from mid October through mid January prices drifted 15 cents lower. Not only did you have the cost of storing, but you would be out another 15 cents per bushel. You would now be faced with the decision of continuing to store even longer to try to recover the 15 cents in addition to the interest that you’ve lost. On the other hand, if prices were to increase 15 cents, that would certainly help offset your cost of storage. Depending on whether your storage is on the farm or commercial would influence the profitability of that decision.

Now let’s bring options into the picture. After you put the corn in the bin in October at $2.00, you also decide to buy a March $2.00 corn put at 10 cents. In performing our breakeven calculation, we take the $2.00 strike price less our 10 cent premium less 2 cents for commission. We leave ourselves with a floor price of $1.88. $1.88 represents the minimum price that we would receive for our corn plus or minus any basis adjustments. In our previous example where corn prices dropped 15 cents, the cash market would be $1.85 by mid January. By using our option, we could sell on the cash market at $1.85 and then offset our corn put. Our $2.00 put would now be worth at least 15 cents in cash value plus any remaining time value. It’s likely we would have 2 or 3 cents time value remaining, so we are up to 17 cents for the value of that option. By selling that option back, we receive 17 cents but must subtract the 10 cents we paid for the option originally and also the 2 cents in commission. Our remaining profit would be 5 cents. We then add the 5 cents to our $1.85 cash price for a total net realized price of $1.90 per bushel.

Notice how this is better than what we would have done just selling in the cash market alone and even a little better than our minimum price we guaranteed. In this case, the use of the option may not look very exciting. The purpose, however, is not to generate tremendous profits, but rather to help you manage your risk. By just storing the corn and being unprotected, if prices dropped to $1.50 (and you don’t need that good of a memory to remember those days), your option would have been a welcome safeguard. On the other hand, if prices rise you are still able to sell at the higher price but will have lost some premium in your option.

The real question is whether you can withstand the risk of loss and how much. One farmer may be able to put grain into storage in fall and risk 20 cents in the cash market. He may not expect prices to drop that much, but if they do it certainly won’t ruin his business. On the other hand, a farmer with a more leveraged operation may not be in a position to absorb that type of risk. In short, the greater the loss you are willing to accept, the greater the profit you may be able to enjoy. That’s a trade-off that is not going to be changed.

Assumptions: Farmer puts corn in storage at harvest.

NO OPTIONS/PRICE GOES DOWN           NO OPTIONS/PRICE GOES UP
Cash price Oct. 15 = 2.00            Cash price Oct. 15 = 2.00
Cash price Jan. 15 = 1.85            Cash price Jan. 15 = 2.20

Net realized selling price = 1.85    Net realized selling price = 2.20
(Interest and storage cost must      (Interest and storage cost must
be subtracted.)                      be subtracted.)

WITH OPTION/PRICE GOES DOWN          WITH OPTION/PRICE GOES UP
Cash price Oct. 15 = 2.00            Cash price Oct. 15 = 2.00
Buy March 2.00 put at 10 cents +     Buy March 2.00 put at 10 cents +
2 cents commission = 1.88 floor      2 cents commission = 1.88 floor

Sell cash Jan. 15          = 1.85    Sell cash Jan. 15          = 2.20
Sell March put at             .17    Sell March put at             .02
2.02                                2.22
– cost of option              .12    – cost of option              .12
Net realized selling price = 1.90    Net realized selling price = 2.10
(Interest and storage cost must      (Interest and storage cost must
be subtracted.)                      be subtracted.)

A key point that I’d like you to gain from this example is that the use of options would not wildly improve the profit or loss. What it did, however, was stabilize the farmer’s income. Remember also that we’re dealing with a fairly small price move and a very short period of time. As longer lengths of time and larger moves are examined, the swings will become more dramatic. Please review the following information and answer the questions on the next page. Answers will appear on Lesson 10. Assumption: Farmer puts wheat in storage at harvest. Stores until January.

NO OPTIONS/PRICE GOES DOWN           WITH OPTIONS/PRICE GOES DOWN
Cash price July 15 = 3.50            Cash price July 15           = 3.50
Cash price Jan. 15 = 2.60            Buy March 3.50 put at 18
Net realized selling price = 2.60    cents + 2 cents commission  =  .20
(Interest and storage cost must      Sell cash Jan. 15            = 2.60
be subtracted.)                      Sell March 3.50 put            +.90
– cost of option               -.20
Net realized selling price   = 3.30
(Interest and storage cost must be
subtracted.)

1. What was the floor price established by purchasing the March $3.50 wheat put? (Hint: Strike price – options premium – commission)

2. In the example where prices fell, would the farmer have been better off: a. Selling the cash grain at harvest on July 15
b. Storing the grain until January 15 with no option protection
c. Storing the grain until January 15 and having the protection of options

3. If prices had risen after July 15 and gone to $4 on January 15, what price would the farmer have ended up with as his net realized selling price that day:
a. If he did not purchase any options —————
b. If he purchased the $3.50 put option —————

4. If the cash price on July 15 was $3.50 and was still $3.50 on January 15, would it have been worth buying a put option?

5. If the premium for the March $3.50 put would have been 21 cents, what would have been the floor price?

6. If instead of the $3.50 put the farmer would have purchased a $3.40 put at 14 cents, what would his floor price have been?

SUMMARY

— Put options provide price protection for crops that are being stored as well as those that are still growing– In selecting the correct strike price, it is important to consider the floor price which is being established. — The higher the floor price that is established, the more profit you are going to take off in case of a rising market.