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Corn+Soybean Digest

Are Options An Option?

It's a popular saying — “Options are like insurance. You just hope you don't have to collect.”

Well, like other insurance, the cost of put options has gone up, so much that many growers shy away from them.

“I don't want to, but my guess is that we might have to use some put options this year, even though they're expensive,” says Steve Henry, Arapahoe, NE, corn and soybean producer. He's looking at buying puts and selling calls to reduce his cost of price protection.

Steven Johnson, Iowa State University Extension farm management specialist, says that if producers understand futures options, they can consider the strategy of selling an out-of-the money call option to offset the high cost of a put option.

“This is especially true if you plan to purchase at-the-money put options,” he says.

An at-the-money corn put option, a position that provides the owner with floor-price protection equal to the level of the futures price the time the option was purchased, can easily cost 50¢/bu. or more. That's $2,500 for one 5,000-bu. contract.

When December 2008 corn futures were trading at about $6.40/bu. earlier this summer, an at-the-money put option, meaning the option buyer would have a $6.40 strike price, would have cost 68¢/bu. So subtracting the options premium charge, the floor price was actually closer to $5.70.

What about soybeans? Try at least a buck a bushel for the premium on an at-the-money put option.

In early June, the November 2008 soybean futures were at about $13.60/bu. However, buying the at-the-money put cost about $1.43/bu., putting the actual floor at about $12.10. Cost of one 5,000-bu. put option contract — about $7,100.

“When you get above a $13/bu. strike price for a put option, the premium is about $1,” says Johnson. “I'm not sure how many producers would pay that kind of premium.”

Jason Moss, market analyst with The Brock Report in Milwaukee, WI, agrees that option premiums are too high. “The point to remember, though, is that the premium is directly related to the average daily price fluctuations, a volatility measure, as well as futures margins,” he says. “The best advice for growers in executing options strategies is to think longer term to properly balance risk protection versus cost. They can choose between different strategies, one that suits them best. A higher minimum price equals a higher cost.”

Henry, whose south-central Nebraska operation also includes custom farming and a seed dealership, tries to sell about half of his corn or soybeans before harvest. “That can give me a 24-month window to spread out sales,” he says.

He prefers to market most of his crops through forward contracts at the co-op. High prices through 2009 and into 2010 make him want to get some early sales in. But with the massive margin requirements forcing him and other grain handlers to limit sales to the current year's crop, he's in a bind.

Options or futures are the alternatives. Options spreads may provide him the best coverage. “I'm looking at a fence,” says Henry, “buying puts and selling calls.”

In a corn options strategy he was considering, Henry would buy out-of-the-money puts in the $5.50 range and sell in-the-money $8.50 calls. Cost of the puts was about 26¢/bu. The calls could be sold for about 20¢.

For only 6¢/bu., he would have a marketing window of $5.50 and $8.50. His risk was limited for very little money.

Henry was bullish in his strategy, in that he anticipated tighter corn acres due to slow planting in the central Corn Belt. Any Corn Belt weather during pollination would have kept him bullish. He refers to it as “gut-check” marketing.

“If it's dry in the rest of the Corn Belt and raining here and basis tightens here, that tells me it's time to sell, either through forward contracts or using futures or options,” he says.

Soybean marketing hopefully will involve forward contracting most of his beans with a new biodiesel plant in his hometown or traditionally with the co-op. “It's a new market for us,” says Henry, noting that he normally doesn't use options on soybeans. However, volatility this year has him thinking twice about them.

“Some options trades may be valid with what we're seeing in these markets,” he says.

Again, at-the-money put options are virtually off the table for Henry and many others. But a spread is a consideration.

For example, with November futures at about $13.60, a $12.60 put could be bought for about 92¢/bu., about 50¢ below the at-the-money put cost of $1.43. To offset the premium charge, a $17.40 call could be sold for about 50¢.

That example provides a marketing window from $12.60 to $17.40. The cost would be about 40¢/bu. That's about $2,000 for the 5,000-bu. contract.

If Henry used this strategy, and the market blew through the $17.40 range, he'd face margin calls, as he would for the $8.50 corn call if that price was surpassed.

Johnson says the spread can be a good strategy. “But recognize the potential margin call that comes with selling options,” he says. “Keeping the call option strike price high enough is key, even though the higher the call option strike price, the lower the premium you receive.”

Moss points out that “in the classic ‘collar’ (spread) strategy, where multiple ‘legs’ are involved, it's risky to partially execute or exit the intended position. “Likewise, always execute the entire position or none at all.”

It seems strange to fear setting a margin position at $8.50, says Henry. “It's astronomical to consider that. I'm setting up a different line of credit to handle the more aggressive marketing.”

He considers marketing as part of preparing his cash flow plan.

“We realize that the minute the ink dries on a cash flow plan, it's wrong,” says Henry. “Too many factors can change. The same can happen with a marketing plan. You just have to have confidence to develop a plan, implement the plan, then live with those decisions.”

MANAGE CROP REVENUE. That's a term often used by Johnson, who says the use of options and futures should coincide with the use of crop-insurance revenue products such as CRC or RA-HP. “Crop revenue products can be used in combination with preharvest sales that commit bushels to delivery,” he says.

“This is especially true when cash sales can be made when the futures sales price is higher than the government insurance spring base price ($5.40/bu. for corn and $13.36/bu. for soybeans in 2008). These amounts do represent the highest spring base prices ever recorded, thus the interest in preharvest marketing strategies.”

Johnson says a balanced portfolio of marketing and risk-management tools is critical in an age of extreme futures price volatility.

Henry uses his variation of the bartering system in matching sales with purchases. “I'm tending to make more cash sales as I buy my inputs,” says Henry. “I needed a load of diesel in June so I sold some old-crop corn for $6.02/bu.

“It's almost like bartering. It can feel like you're playing with Monopoly money. You make sales to buy inputs to hedge your bet,” he says.

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