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Time for options?

Agriculture.com Staff 02/08/2016 @ 8:32am

When I bring up the subject of options in a marketing meeting, I get one of two responses. The first is that they do not understand options and how they work. The second is that the individuals have tried options and lost money. The first obstacle can be overcome by attending an options workshop or studying an option book offered by the CBOT or Extension Service.

The second obstacle is more difficult. My experience with options is that farmers usually lose money because for one of two reasons. The first is that they buy options indiscriminately without thinking through the strategy or timing. Or, the option strategy that they choose is not appropriate for what they want to accomplish.

Options work best when the market is in a long trend. Long term seasonal charts show the most reliable trend is from spring until harvest. That trend is down in about 70 percent of the years. Therefore, put options are appropriate for pricing new crop soybeans and corn. To minimize time value during that period, the longer you can wait to buy the option, the less the premium cost will be.

With prices and volatility high as they are now, option premiums are expensive. My experience is that when premiums are high, the odds of a big payoff are also high. For example, last year at-the-money puts cost 40-50 cents or more for a long time. However, by harvest any option with a strike price over $5.00 ended up being profitable.

We are at what is normally the time for high prices in the grain markets. With all of the uncertainty in the markets, it would appear that this is an ideal time to use options. For instance, with November soybeans closing at $10.80 on Thursday, a $10.80 put option premium was $1.06. The net from such an option purchase would be $9.76. While this might seem like a lot to pay for this price protection, compare that to a market move of 40-50 cents in a day. Another approach to pricing beans would be to lock in the crop insurance rate of $8.80 per bushel. With cheaper out-of-the-money puts, a $9.20 put at 36 cents would lock in $8.84.

Another way to look at options uses a similar example in the corn market. In March I sold December corn for $4.30. That is $.26 above the crop insurance guarantee. With an average yield on my farm it locks in a profit after all expenses are paid. However, today the strategy does not look so smart. As of Thursday I have 41 cents margin money in that transaction. If I had used a put option and the at-the-money premium was the same as today, it would have cost 53 cents. Today that out-of-the-money option premium is 32 cents, of a loss of value of 21 cents, or half of what I now have invested in margin money. If the futures price continues to go up, the option strategy will look even better.

I don't normally use options as my only means of pre-harvest pricing. The first increments that are done earliest and cover the bushels I am most comfortable with producing are sold using futures or cash forward contracts. Later in the production season, after some of the time value has expired, options are a good choice. That is especially true when price direction is uncertain and prices are high. Both of these conditions describe today's grain markets.

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