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A Year to Use a Put Option Contract, Analyst Says
This year’s final yield results for corn is anyone’s guess. Volatility is high, fueled by a late and cool spring, with the idea that it will take near-ideal weather to achieve a crop size even close to average.
As a result, futures and cash prices are in a steep recovery, gaining close to a dollar from new contract lows posted just over a month ago. The bulls are in charge, anticipating higher prices. Yet, history tells us this: Markets that move up will move down, often just as fast. One day you feel you should have sold nothing, and the next day you feel you should have sold everything. What tool can you use to help manage this volatility? Consider using put options.
Put options are purchased through a licensed adviser and traded at the Chicago Board of Trade. The owner of a put has the right (not the obligation) to sell futures. A put can be exercised (converted into a short futures position).
Put options are priced from an underlying futures contract and expire about one month prior to the futures last trading day. As an example, December corn options expire on November 22. When purchasing a put, you determine a strike price, which is the level of protection. These come in 10¢ increments. For example, you could purchase a December $4.40 corn put, a December $4.50 corn put, or a December $4.60 corn put. The higher the strike price and the closer to the futures market, the more it will cost. Time is also a pricing component. The total cost of an option is dependent on time, proximity to futures, and volatility. The seller of the option is incurring unlimited risk.
As futures prices move higher, put options will decrease in value. However, as volatility picks up, higher futures prices do not necessarily mean put options will decrease in value. Why? Higher volatility (a pricing component) is kicking in. Because of this, some producers say they will not use options because they are overpriced. When asked to defend what this means, they usually come up short. What they probably really feel is the lack of price decay compared with a nonvolatile (quiet) market, where lack of volatility keeps option prices subdued. Bottom line, as volatility picks up, the seller requires more premium for risk. You should not let higher volatility premium scare you away. In fact, you should view higher volatility premium as a signal that the market could be too high, and may potentially fall apart.
The beauty of a put option is that it provides a flooring mechanism without the obligation to deliver. This is a year where you may have late-planted corn, prevent acres, or both. A put option might be the more desirable tool instead of forward contracting or hedge-to-arrive contracts, which require delivery. When you purchase a put, the premium paid is the maximum risk, unless you exercise it. In contrast, there is no premium when selling futures, though you could be subject to unlimited risk. Establishing a price floor with a quantified risk, while leaving your crop unpriced for appreciation, may be attractive. In times of high volatility, with the possibility of prices moving significantly up or down, this may be particularly attractive.
If you have comments or questions, or need help implementing put option strategies, contact Top Farmer at 800-TOP-FARMER, extension 129, and ask for Bryan Doherty.
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.