A put option works when futures markets rally and basis widens, analyst says
A put option is a risk management instrument that is traded at an exchange.
The buyer of a put option has the right but not the obligation to sell futures. A put option can be viewed as a tool to establish a price floor in a market, while it allows the cash commodity to participate in a price rally. In this Perspective, we’ll take the approach of using a put option if you are a corn producer.
Each year a corn producer will plant so many acres and estimate total production based on a historical yield. As market opportunities arise, many will, prior to harvest, attempt to shift risk.
Typically, but not always, prices are higher in the winter and spring than they are in fall when harvest brings supply to the marketplace. Risk shifting can be done using forward contracting, hedging, or other instruments.
If a farmer chooses to purchase a put option, he is usually establishing a price floor on bushels he is not intending to sell prior to harvest. Therefore, in a year like this one where prices have rallied substantially, the idea of establishing a price floor makes sense. Unlike a forward contract, a producer is not obligated to make delivery when purchasing a put. Many farmers use a combination of forward contracting and put options. Puts are also flexible. When you own a put, you can sell it any time. Or, if you choose, you can exercise it and convert to short futures.
The argument for using put options this year is that prices have rallied substantially as supplies have dwindled. Additionally, there is always a risk to producing a crop in any growing season as weather is the biggest factor affecting production. Therefore, in a year of tight supply, if less than ideal weather develops, prices could rally substantially. By purchasing a put, a farmer could put a floor in the market and participate in the rally, pricing cash grain later.
Another reason to use a put is that, typically in a strong futures rally, basis widens. Therefore, forward contracting may not be an attractive alternative. On the other hand, if there is a strong basis, a farmer may be better off forward contracting. Yet, there is still the dilemma of how much to forward sell.
Current new-crop corn futures are trading near $5.50 on the December Chicago Board of Trade contract. It does not take a vivid imagination to imagine prices back to $4.00 on good weather. On the other hand, weather could drive prices to all-time new highs over $8.00. The purchase of a put is a good alternative in a potentially volatile market.
When purchasing a put, determine the level of protection you desire. This is called a strike price. You also want to purchase the appropriate timetable. Typically, puts are purchased based on December corn futures, as they provide protection into the harvest season. The cost of a put option is called premium. In volatile markets, premium is more expensive than when prices are trading in a sideways or low volatility pattern. The amount of time is also a price determinate. The more time you buy, the more an option will cost.
There are many considerations when it comes to marketing. Make sure that you look at all marketing tools and have a working knowledge of their potential benefits and risks. Work with someone who is unbiased and will help you to achieve your goals and who can implement the right strategy for you.
Keep in mind, nothing is free. Options do cost dollars, but often these are dollars well spent in creating and crafting a marketing strategy to shift risk and take advantage of opportunities. Find a lender who has a working knowledge of marketing tools and is willing to work with you. 2021 promises to be volatile. Finding the right tool at the right time for the right reason is part of a strong marketing strategy.
Futures trading is not for everyone. The risk of loss in trading is substantial. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not necessarily indicative of future results.