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Options Alternative

Agriculture.com Staff 01/17/2008 @ 12:30pm

With the volatility in today's marketing, options offer a viable alternative for pricing new crop grain where production risk is a concern. Most farmers prefer to buy call options to replace grain already priced using cash contracts or futures. This usually results in buying high and selling low, resulting in the premium being lost. Buying put options to put a floor under the futures price has a better track record.

In the "Winning the Game" workshops, buying put options is promoted as a method that is better than leaving the grain unpriced but not normally as good as forward contracting. In preparation for this year's series of meetings, I made a comparison between put options, futures hedges and doing nothing. I based this example on actual 2004 prices using a strategy that I actually used on my farm. On March 21, 2004 the November soybean price was $7.80. A $7.80 put option was $.80. I anticipated harvest basis of -$.40.

Pricing with a cash forward contract would have netted $7.40 at harvest. Forward pricing with a put option netted $7.80 minus $.80 premium minus $.40 basis, or $6.60. Clearly the premium cost on the option reduces the net price. However, at harvest, November futures were $5.40. Doing nothing resulted in a price of $5.00, or $1.60 less than the option.

Using options offers flexibility that other strategies do not. With the option, you still own the grain at harvest which can be priced on the 'dead cat bounce' or stored until the following spring. The put option can be rolled down to take profits off the table. In some cases spreads can be used to reduce the premium costs. The longer you wait to buy the option, the lower the premium cost will be, if the futures price is the same. All of these choices are management intensive practices for which experience with options is an advantage.

Looking at today's price scenario, a floor of around $10.50 can be purchased under new crop soybeans based on a harvest basis of -$1.00. The outlay of over a dollar a bushel premium seems large. However, when you consider that the floor price is higher than any price available for the previous 30 years, it is a tool that makes sense for at least a portion of the new crop soybeans and corn.

With the volatility in today's marketing, options offer a viable alternative for pricing new crop grain where production risk is a concern. Most farmers prefer to buy call options to replace grain already priced using cash contracts or futures. This usually results in buying high and selling low, resulting in the premium being lost. Buying put options to put a floor under the futures price has a better track record.

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Farm Science Review, Day Two