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Using put option contracts in a weather market

It's about protecting your bottomline, analyst says.

In weather markets, commodity prices can move dramatically in a short period of time.

One way to protect against downside price movement is to establish a price floor using put options. Put options are purchased through commodity brokers or sometimes through elevators, and traded at the Chicago Board of Trade.

When using a put option, your goal is to establish a price floor yet leave your physical commodity unpriced, which allows it to participate in upward price advances. It doesn’t take a vivid imagination to expect corn and soybean prices to rally significantly, if current forecasts hold for well-above-normal temperatures for the second half of July and early August.

Yet, prices can plunge on a change in the forecast or if rain totals are better than expected. Current projected supplies are considered nearly burdensome for both corn and soybeans.

When purchasing a put option, the price you pay is dependent on the amount of time you buy, the proximity to the futures price, and volatility. A (sort-of) rule of thumb is that put options generally cost about what commercial storage costs on a monthly basis. For many, the biggest advantage to the buyer of puts is the peace of mind, knowing you have protected your bottom line.  Your risk is fixed to the purchase price plus commission and fees. You, as the owner of the option, have the right to sell futures, with no obligation to exercise that right.

After you purchase a put option, usually one of three scenarios will occur. Your action will likely depend on what happens to the value of your option based on the movement of the underlying futures contract.

Options have a certain life span and usually stop trading about three weeks prior to the last trading day for futures.

One scenario is that, at expiration date, the futures price is higher than the level of protection you purchased (the strike price), and the option expires without value.

A second scenario is that, at expiration, the futures market is below the strike price and, consequently, your option is exercised into a short futures position. This is usually done when the trend is lower, and you want to maintain a more defensive posture for a longer period of time. You will, however, incur the risk of establishing a futures position, which is unlimited.

A third scenario is, instead of exercising your option, you sell it in the marketplace. This is the scenario that occurs most often with put options that are in the money, and utilized if you want to maintain a fixed risk.

Another advantage of put options is that you have flexibility. When you purchase a put, you’re not required to hold it until the option expiration date. As an example, if you purchase a put in front of a USDA report and the market responds to the report in a very negative fashion, increasing the value of your put well beyond the purchase price, you might decide to exit at that time.  Or, if you notice the weather is getting drier, you believe the futures price will rally and you want to step aside to preserve capital, you can do so. The point is that options provide you many alternatives.

Put options are just like any other marketing tool, in that they have their pros and cons. Before entering any position, make sure you understand all aspects of the risk associated with that position and your alternatives. Puts are used in a manner by farmers to protect the downside, typically in bushels they’re not willing to forward contract. For many, put options also provide peace of mind, knowing that if prices move lower, you have protected yourself against downside price movement with a quantified risk.

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If you have questions or comments, contact Bryan Doherty at 800-TOP-FARM, extension 444.

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.
 

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