November 23, 2022
Woody Hayes, the late great football coach of Ohio State University once said, "Three things can happen when you pass the ball, and two of them are bad."
He may just as well been talking about Peter Paperfarmer. Peter re-owned grain sales at harvest with the purchase of call options. Prices move in one of three directions - up, down or sideways – and two of the were bad for Peter.
Covered call options
Let’s consider a character who can benefit from two of three price directions. Covered Cal sells covered call options against unpriced grain in storage. Like many producers, Covered Cal has on-farm storage. He puts his crop into storage at harvest and on November 1 he sells at-the-money July call options. Cal maintains his option position until he sells his cash grain on the Friday between May 25-31. His price is the cash price of corn or soybeans at the end of May plus the profit or loss from selling ATM calls. His price is also net of variable storage costs (interest on debt and shrink).
By selling options, Cal receives the call option premium. If prices trend sideways or lower (two of three scenarios), Cal gets to keep the premium. His risk is in the upside – as prices rise, he will take losses on the sale of call options. However, because Cal has unpriced grain in storage, he is “covered” (i.e., protected) if July futures prices rise and call options expire in the money. He also has risk in a sharply lower market - if prices crash, Cal’s “hedge” is limited to the premium.
Selling covered calls is essentially a flat market strategy that offers a limited return and a limited hedge, with both defined by the size of the premium.
Prices are based on CME Group closing futures prices and the actual basis per average Iowa prices gathered and reported by USDA AMS Grain Market News and summarized by the Iowa Department of Agriculture and Land Stewardship. Barney’s corn price is set on the Friday between October 12-18. His soybean price is set on the Friday between October 5-11. At harvest, Covered Cal holds his grain "unpriced" in on-farm storage. On November 1, he sells at-the-money July call options. Cal maintains his option position until he sells his cash grain on the Friday between May 25-31. His price is the cash price of corn or soybeans at the end of May plus the profit or loss from selling ATM calls. He pays 1 cent per bushel in brokerage fees. His price is also net of variable storage costs, which include interest on debt (assumes a line of credit) and in-and-out costs to account for shrinkage (8 cents and 11 cents/bu., respectively, for corn and soybeans). Cal, like all my producers who store grain, is limited to holding 80 percent of his harvest in on-farm storage. The remaining 20 percent is sold at harvest, at Barney’s harvest price. This 20 percent sale at harvest is reflected in the average prices shown above.
Cal’s return over the years has been solid, particularly in corn. From 1989-2021, Cal received an average price of $3.15 per bushel, or 17 cents better than Barney (see accompanying table). He also had a price better than Barney’s in 26 years. In 9 years, Cal’s price was 10% better than Barney’s harvest price, while which is another way of saying that in 9 years, the premium received by Cal was greater than 10% of the harvest price (options can be expensive). Barney beat Cal by more than 10% in 2 corn years.
In soybeans, Cal received an average price 34 cents better than Barney. He also had a price better than Barney’s in 26 of 33 years. In 6 years, Cal’s price was 10% better than Barney’s harvest price.
Cal’s results should pique our interest in a different approach to pricing grain. However, the last two years have been hard on Cal, even though he had a better price than Barney. July futures prices moved sharply higher from harvest to early summer in each of the last two years. He received a great cash price, but some of that was needed to cover large losses from selling call options. Red ink in the margin account never feels good.
If you have a stake in grain price direction, you can’t help but get caught up in the talk of a bull or bear market. But market direction is not always up or down. Sometimes they are stuck in a trading range, and Covered Cal has a strategy that works best in a sideways market.
Meet the rest of the crew:
Ed Usset is a grain market economist at the University of Minnesota, and author of the book “Grain Marketing Is Simple (It’s Just Not Easy).” Reach Usset at [email protected].
The opinions of the author are not necessarily those of Farm Futures or Farm Progress.
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