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Options confusion?

Agriculture.com Staff 12/21/2007 @ 1:37pm

A thread on the "Marketing" talk page from "ontheridge" generated several responses warning of the consequences of doing a spread if the price of corn goes over the strike price of the option sold.

The response of the readers indicates just how bullish farmers are. For those who are considering some type of option strategy, a review of option principles from someone with 24 years of experience is in order.

I will start out with some general principles. First, option strategies that involve more than one transaction usually result in added commissions for the broker without adding profit to the farmer. Secondly, individuals who have never used options before should stick with a simple strategy of buying a put or call. Adding additional transactions adds a degree of confusion that may be difficult for the beginner. Third, getting options orders filled can be difficult. In my most recent options trade, I had the only trade of the day for that strike price. Multiple transactions compound this problem.

Having raised all of the above red flags, options are very flexible. In certain circumstances, multiple transaction strategies offer price protection at a very low cost. At other times, they can give you exposure to market moves with very low risk. Examples of the latter are bull call spreads or synthetic puts.

In the strategy explored by ontheridge, the risk is margin call exposure if the price of corn rallies substantially. How great is the risk of corn futures going over $5.40? I do not know. If 'ontheridge' has corn in the bin, the value of the corn will offset the margin call risk. He may have to put in more margin call money, but he will get it back when he sells the corn for a price inflated from today's futures market.

I see two risks in this strategy. The first is that he gets whipped psychologically and bails out before the strategy has a chance to work. In that case, he might buy back the call while there is still time value left. The second is that he procrastinates, does not get it implemented, and the market drops leaving him with no protection. It is absolutely essential to remember that his goal is to have a floor under prices while leaving open the opportunity to benefit from a price rally. The strike price of the sold call limits how much of a rally he will benefit from.

A possible variation of this strategy would be to purchase the put option now to implement the price protection he needs, but wait for a higher futures price to sell the call. Splitting up the trade adds the risk that he might not get the call sold. It adds the possibility of getting more premium on the short call or selling it at a higher strike price.

Last March, I had a call from a banker and a farmer who were exploring a strategy for pricing new crop corn very similar to the one proposed above. He was questioning what could go wrong. The strike price of the call he was proposing to sell was far above the level guaranteed by crop insurance. He was willing to finance the farmer's margin calls if it became necessary. I told him that the biggest risk was that they not get the transactions done. A couple of weeks later I inquired as to how the marketing was going. The response I got back was that is sure was easy to see opportunity and let it go by without taking action.

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