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New approach to crop marketing

In the last four years, I have recommended a three-step risk-management plan that suggests: 1. Buying RP crop insurance. (The right policy is a complex decision that you should work with a qualified crop insurance professional.) 2. Getting the majority of your insured bushels sold ahead. 3. Getting the balance of the bushels covered with put options.

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But times have changed, and now my approach will change. I have become more and more disillusioned with results when I use puts.

The real transformation in my thoughts and recommendations came about at my own Lafayette Trading Academy. When the other instructor, Corey Redfield, showed several powerpoint slides comparing hedges to puts, I knew, after looking at those results, I had to change the way I would make recommendations.

These are the two main points that I noticed on the spreadsheets:

● In three of the last four years, having new crop corn and soybeans hedged ahead had been the right financial and marketing decision. In plain English, it made more money.

● In three of the last four years, buying new crop puts has been a waste of money. Only in 2008, when grain prices crashed lower during the great financial meltdown, did put options work. However, in 2008 when puts did work, hedges worked even better.

“Times have changed, and now my approach will change. I have become more and more disillusioned with results when I use puts.”

Penciling it out

I studied many different scenarios and other risk-management alternatives. I worked them back to see how they would have performed in the last 10 years. I used a proprietary rule-based system to make cash and new crop marketing decisions. I then used my research to change the rules. I made some changes by fine-tuning the plan, and I used different percentages of hedges and/or puts.

I found that in eight out of 10 years, having 10% to 20% more corn and soybean crops hedged gave better financial and marketing returns than if 40% to 50% of the crop was hedged and new crop put options were used on the balance.

In the few years that puts do work, you do not make enough extra to cover your losses in the other years.

I then studied the years that puts worked to see if I could determine analogue years that I could use to identify years when puts were more likely to work. I then looked closely to see if I could tell which years puts were more likely to work.

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Consider buying the puts because it locks in a price that is higher than your RP crop insurance.

Only buy puts if you can lock in a breakeven that is above the RP crop insurance guarantee. Figure your breakeven on a put option by deducting the premiuim you pay from the strike price you purchase. Buy a $6 December 2012 corn put for 30¢ or less and a $13 November 2012 soybean put for 40¢ or less if futures rally into late June. Otherwise, wait until next year.

“This complex strategy is not for everyone. But if you understand how puts work, they can pay big dividends.”

2 Simple rules

In my research, I did find two rules that can help me be more selective in making put purchase recommendations. (Note: I would only use puts in the years when they are likely to work.)

1. I will only buy puts if my breakeven is higher than the price level I have locked in with RP crop insurance policy. For 2012, that means I will have to buy a corn put that locks in a breakeven price of over $5.68 per bushel. For soybeans, the breakeven price has to be over $12.55.

2. I will only buy puts if new crop futures rally from a February-to-March low to a high in late June to early July.

Both rules must be met. This only happens about 25% of the time, which coincidently is about how often owning puts has worked in the last 10 years.

So do I ever see a time when put options are the right alternative for farmers to consider? Yes absolutely.

Here are three scenarios where I suggest you consider using puts:

1. When you have no storage and need to get 100% of your new crop corn sold off the combine. Then a combination of forward contracts, hedges, and puts should be considered.

2. When you want to protect cash corn inventory ahead of major USDA Grain Stocks reports. When I thought the reports would be negative but still wanted to hold onto the grain for the next 30 to 90 days, I would recommend buying puts.

3. When livestock feeders who need to keep cash corn around for livestock feed, but they wanted to protect the inventory value.

Puts can work for you

Puts can work, but you need to be very selective and disciplined in choosing when to use them.

While doing the research, it occurred to me that if buying new crop corn and soybean puts work so seldom, why not sell them?

This complex strategy is not for everyone. But if you understand how puts work, they can pay big dividends.

Odds are good that by the time you read this, I will have 30% to 50% of the new crop corn and soybeans hedged ahead. I will either be short some new crop calls or short new crop puts depending on what my rules tell me to do. This works especially well if you have RP crop insurance.

If you are working with a broker or an adviser who is always advising you to buy put options every year and then rolling them up or down, odds are good that adviser is working to generate commissions – not working to get your farm positioned correctly.

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