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Don't let option costs scare you

Agriculture.com Staff 02/06/2016 @ 7:37am

In recent weeks we have heard a common theme from farmers, and that is they believe that PUT options are overvalued.

When asked to explain what they mean by overvalued, most do not have a good answer. We believe they are looking at the cash flow or cost per PUT option. Dollars needed per option are more compared to past years, but when breaking down the cost, it is necessary to measure all relative pricing variables, such as the value of futures, time and volatility.

As an example, when purchasing an at-the-money PUT option, you should expect to pay approximately 10% of the value of the futures contract. For example, in past years, if buying a December 280 PUT, you would expect to pay somewhere in the ballpark of 28 cents. With futures prices over $5 a bushel, an at-the-money PUT option will cost 50 cents or more. Keep in mind that someone has to be willing to sell the PUT option, and they will require more premium if they believe the odds are higher that the market can work against them (in other words, futures prices drop). Therefore, the higher futures prices move now, the higher the volatility component and overall PUT option premium will be.

When looking at what a PUT option does, establish a price floor with unlimited price appreciation potential for your cash grain. This serves a critical function for producers to protect unpriced bushels. As an example, a farmer may forward contract 30%-50% of his crop and use hedge-to-arrive or futures contracts for another 10%-20%. There may be about 30%-50% that is unpriced. By using PUT options against this unpriced inventory, you can go into summer prepared for weather markets to push prices higher or lower, maybe dramatically. If prices move higher, the unpriced grain appreciates. If prices move lower, your PUT options provide a price floor.

A thorough understanding of options is important to be a productive user of PUTS. We encourage farmers to take time to learn the ins and outs of how options work, are priced, and how they move relative to the futures market. We see options as a critical element to help tame the volatility that lies ahead.

If you have questions, comments or would like to learn more about PUT options, contact Bryan Doherty at Top Farmer at 1-800-TOP-FARM ext. 129.

In recent weeks we have heard a common theme from farmers, and that is they believe that PUT options are overvalued.

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