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Holding crop is risky

11/18/2011 @ 1:10pm

If you have recently finished harvest, you might have a significant amount of inventory that is unprotected from a price decline. Storage has been a good alternative in recent years. However, the market is currently priced at historically high levels, and with uncertainties in Europe, as well as the potential for large South American crops, prices could come under pressure. Therefore, holding too much unpriced crop could mean big risk.

There are two strategies we will review in today’s Perspective. First is the purchase of a put option in order to establish a flooring mechanism. A second strategy is an option fence. This is where you purchase a put and sell a call option. For example purposes, we will work with March options. In addition, our example will also use March corn priced at $6.50, and use the $6.00 put strike, as well as the $7.40 call strike.

You purchase a put option to establish a price floor against a future price decline. By purchasing a $6.00 March corn put, currently near 18 cents, you have bought the right to sell March futures, however, not the obligation to do so. As of this writing, there are 100 days until expiration, which is February 24th. Expiration is the last day in which you may utilize this option. Options also have flexibility in that, once you purchase a put option, you can at anytime attempt to sell it. 

Let’s say you have 50,000 bushels of corn in storage that is unpriced. You purchase ten put options, each covering 5,000 bushels. You would have a flooring mechanism against March futures at $6.00. However, your true floor is $6.00, less the 18 cent premium, less commission. Most likely your floor is somewhere close to the $5.80 area. Is this a good strategy? It’s hard to tell when purchasing an option. With hindsight, one can easily see what may have been the best strategy. However, if you are intent on holding corn unpriced in storage, and you want to minimize your exposure to a market sell-off, this strategy makes a lot of sense. If you are trying to protect every penny of value of corn in storage, purchasing a $6.00 put is not necessarily the best strategy. In that case, you would want to purchase a much higher strike price option. However, as you move up in strike price levels, your cost will increase, and with ten contracts that could be pricy. Therefore, you need to weigh cost versus the functionality of the strategy and what it can or cannot accomplish. 

A more advanced strategy is the purchase of a $6.00 put for near 18 cents, and a simultaneous sell of a $7.40 call option for 13 cents. You now have a strategy that gives you the right to sell corn at $6.00, but not the obligation. You also have a position with a short call that gives someone else the right to own corn at $7.40, however, they do not have the obligation. By selling a call, you act as the insurer against higher prices. This means, if the owner of that call decides they want to exercise this position and be long futures at $7.40, you are agreeing to take an opposite position; that is a short futures at $7.40. Your goal with a fence is to collect premium on the short call to help offset the cost of the long put. Unless March corn futures are above $7.40 at expiration date, this option will expire worthless and, in essence, cut the cost of your put option from 18, less 13 cents, minus commission. 

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