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Corn+Soybean Digest

Courage Calls, Or Puts?

What is the best pricing tool to take advantage of preharvest pricing opportunities? Your choices fall into two categories: fixed-price tools and options-based minimum-price tools.

Fixed-price tools include a simple forward contract, or a hedge-to-arrive (HTA) contract, for harvest delivery. One more way to establish a price at harvest is to sell new-crop futures contracts.

Each of these fixed-price tools has weaknesses. Forward contracting often involves locking in a less-than-favorable basis. HTA contracts often involve a fee. Selling futures exposes you to margin calls. Their common challenge: Once a price is established before harvest, you say goodbye to the upside potential of a weather-driven market during the growing season.

Options are costly, but they are the only pricing tools that allow us to establish a minimum price while retaining upside potential.

I want to introduce you to Peter and Paul Paperfarmer, twin brothers and celebrity farmers who use options to price grain before harvest. Together, they shed light on the value of put and call options in preharvest marketing.

Peter Paperfarmer prices 25% new-crop increments in March, April and May, using a HTA contract for harvest delivery. He re-owns each sale with an at-the-money call option.

These calls are often referred to as “courage calls” because purchasing call options gives Peter the courage to do what he should do: price grain for new-crop delivery during the spring.

Paul prices 25% increments in March, April, May and June, by purchasing at-the-money put options. Paul holds his put options until mid-October harvest.

There are other important differences in their approach to pricing grain.

  • First, because of the delivery commitment in HTA contracts, Peter limits his preharvest sales to 75% of his expected crop, in-line with his revenue-based crop insurance coverage. Put options have no delivery commitment — Paul buys puts to cover 100% of his crop.

  • Second, Peter sells his call options on Sept. 15, when the threat of a weather market has passed. Paul sells his put options a month later at harvest (mid-October).

  • Barney Binless represents the harvest price in mid-October.
  • The analysis assumes no cost for the HTA contract and 1¢/bu. brokerage fees for options.
  • Between 1990 and 2008 (19 years), Peter and Paul used options in preharvest marketing 15 years. Peter and Paul only take action if prices are at or above a minimum price objective, consistent with their breakeven cost of production. Preharvest prices in the spring remained below their minimum price objectives in 1993, 1999, 2002 and 2005.

This table shows the average performance for Peter and Paul, comparing both to the cash corn price at harvest. I am impressed that Peter's use of HTA contracts and re-ownership with call options delivered an average corn price 10¢ better than the harvest price. Paul's purchase of put options found 5¢ more than Peter.

My work allows me to travel widely and speak with many grain producers. Not every farmer uses options to price grain. Among those who do, it's my impression that Peter's “courage call” approach is 2-3 times more popular than Paul's purchase of puts. Why?

Human nature rules. Buying puts is like buying auto insurance — the best-case scenario occurs when you don't get paid.

Peter's approach is more common because we want higher prices, and owning call options is compatible with our hopes for the market.

I prefer put options. No delivery commitment means Paul can be more aggressive and cover uninsured bushels. It also makes Paul a free agent at harvest — his bushels can be delivered to the best market, or placed in storage for postharvest opportunities.

Ed Usset is a grain marketing specialist for the University of Minnesota Center for Farm Financial Management (CFFM). He can be reached at [email protected].

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