Using call options to create a balance in grain marketing
It looks like the year ahead could be filled with opportunity and (potential) frustration. Prices are offering some of their best levels in nearly a decade.
Yet, new-crop futures contracts in corn and soybeans are trading at a significant discount to old-crop contracts. Strong demand and a smaller-than-expected crop this past year have put a premium on stored bushels vs. what is expected to be produced this growing season. The natural tendency for producers will likely be to wait to make new-crop sales, anticipating that prices eventually will catch up. The calendar reminds us that planting season is getting closer by the day. Typically, if the market does not sense a spring planting delay, prices tend to peak in the weeks ahead. Bottom line: How can you make sales at good prices and still participate in a rally that either catches up to old-crop prices, or weather that affects production?
Forward contracting is a powerful tool that many farmers use to sell a percentage of production well before it is produced. Contracting ahead allows you the opportunity to lock a price and shift downside risk. For the purposes of this Perspective, consider forward contracting and hedge-to-arrive contracts as the same tool. Both protect downside price risk, however, your basis is not set in the hedge-to-arrive contracts. The hesitancy many producers are feeling currently is that the market is putting a premium on old crop due to tight supply. This makes it very difficult to be an aggressive new-crop seller. This is where using call options is important.
By purchasing call options, you can retain the ownership of forward sold contracts on paper in a separate account through a broker. Calls are traded at the Chicago Board of Trade. The buyer of a call has the right (not the obligation) to own futures. The price of a call option is dependent on the amount of time you are purchasing, market volatility, and proximity to futures. The level of upward price protection is called the strike price. Strike prices are every 10¢ for corn and 20¢ for soybeans.
There are two benefits to purchasing a call option. The first benefit is the ability to stay long the market in which you have already forward sold. This could be critical if you forward sell now and then prices rally to where old-crop prices are (currently 1.00 for corn and soybeans), or adverse growing weather this summer sends prices skyrocketing. Fear is a motivator and most farmers right now are not motivated to sell new crop despite good prices, because of the fear of selling too soon. Buying calls can temper that fear.
The second reason to consider purchasing call options is confidence. Some producers purchase call options as they sell. Others may purchase call options prior to selling, anticipating a price rise in futures. The goal here is to have calls in place so that when futures rally up to a certain level, you can make sales without hesitation. Many producers feel buying calls prior to an anticipated price rise provides a level of confidence and the discipline to sell from a predetermined non-emotional plan. Purchasing a call option prior to making a sale could be a significant risk if cash sales are not made. Should prices move lower, you could lose in the cash market and lose value in the call option.
By forward selling and purchasing calls, you have created a balance in your marketing. When it comes to marketing, almost everything has a cost or risk associated with it. Understand the risk of purchasing a call option. Just as important, understand how you intend to manage your call option. Forward selling usually does not require upfront dollars to implement. Calls, however, will likely need to be financed at the time of purchase. Make sure you have a comprehensive conversation with your lender so when the time is right, you have cash available to create a solid and balanced marketing approach. Both bulls and bears will fight it out this year. Choose strategy over outlook.
If you have comments, questions, or suggestions, contact Bryan Doherty at Total Farm Marketing. You can reach him at 1-800-TOP-FARM, extension 300.
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.