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Corn+Soybean Digest

Marketing with Multiples

“If you can't live with $5.80 corn or $15 soybeans, don't use this strategy.”

That's not a warning from Gary Hinz, just advice to growers considering the use of multiple-spread options strategies. Hinz is a former farmer who had some success in using futures and options, so much that he decided to become a licensed commodity broker in the mid-1980s.

The McCook, NE, marketing consultant works primarily with growers in western Nebraska and northwest Kansas. He'll take an order for a simple put or call option or straight futures hedge. But he prefers helping producers put forth a corn or soybean marketing strategy that has a high floor price, high upside potential and reasonable overall cost of protection.

Using upward futures market prices seen after the January USDA crop report, Hinz lays out a sample multiple-spread strategy for corn and beans. December 2008 corn was trading at $5.13/bu. November 2008 soybeans were at $12.45/bu.

“Growers could have bought a $5 December put option for 40-45¢/bu.,” says Hinz. The grower has price insurance, but at a steep cost.

“That's a lot of money (about $2,000 on one 5,000-bu. contract),” he says, “but by selling a call against the put, the cost of price protection can be reduced.”

IN HIS STRATEGY, Hinz offset the $5 put and 40¢ cost by selling a $5.80 December call for 28¢, or about $1,400 for one 5,000-bu. contract. That lowered the cost of protection to about 12¢/bu. (40¢ minus 28¢) — about $600 for one contract.

“You have $5 for the floor price and $5.80 for the ceiling,” says Hinz.

But the cost of protection can be lowered even more by selling an out-of-the-money put with a $4 strike price. The $4 was sold for 6¢, or about $300. The additional sale of the put lowered the overall cost of protection to about 6¢ (about $300), with a market window of $1 to a ceiling of $5.80. Selling a $4 put does, however, expose you to a downside risk, in the event of a market price collapse.

He notes that a grower will get margin calls if the price rallies after initiating the trade, even before the $5.80 strike is reached. “But if futures are below the $5.80 when they expire, they would get all the margin money back,” he says. “If the market is above $5.80 at expiration, you would only lose from $5.80 up.

Chris Hurt, Purdue University Extension economist, says a window strategy works well when one wants to establish a minimum futures price, but is also willing to accept a futures price. “It is also best executed when futures markets are near their highs as we may see this winter,” he says.

“By selecting the strike prices for the put and call, one can establish the downside and upside windows that they desire. For example, some would like to have no downside window, or, say, buying a $5 put with a $1 upside window by selling a $6 call. This gives a futures range from $5 to $6.

“But of course there is a catch. The put is going to be more expensive, say 50¢, and the call will only generate about 20¢. So this has a net premium cost of about 30¢ (50¢ minus 20¢ received for the call). Plus there will be commissions of say 4¢/bu., for a total expected cost of 34-36¢/bu.,” Hinz says.

Not everyone thinks that this strategy is advisable, due to its high risk. For example, Ed Usset, grain marketing specialist at the University of Minnesota Center for Farm Financial Management and Corn & Soybean Digest marketing columnist, considers it “a fairly sophisticated and advanced topic.” He says: “All options strategies have a weakness or two. Consider, for example, the scenario where prices drop fast, creating margin calls, and your ‘minimum’ price is not necessarily the actual minimum. It's complex, and there are countless nuances in options trading.”

Hinz elaborates on how the strategy would work for soybeans: He says that in mid-January, a multiple-spread strategy could be locked in for soybeans, with the November 2008 futures at $12.20/bu.

“We bought the $12.20 November put for $1.16/bu. ($5,800 for one 5,000-bu. contract),” says Hinz. “We also sold a $15 November call for 53¢. We cut the cost almost in half.”

The result was a market window of $12.20 to $15 for a cost of $3,100. But to lower the cost more, he sold a $10.20 put for 28¢ ($1,400 for one contract). That left a floor price at $12.20 with $2 of downside protection and a ceiling of $15, for a cost of $1,750 plus initial margin money.

As with corn calls, growers would be subject to margin calls if the price went up after initiating the strategy.

HURT SAYS USING a three-option position has an unbalanced position, or a “naked options position” as it's known in the trade. Selling the third put option at $10.20 makes this unbalanced and essentially says the floor is only established with futures prices between $12.20 and $10.20. If futures prices drop below $12.20, he says, then the producer is exposed to losses on the call for futures moves below $10.20.

It's a strategy that has a little more risk, but at a lower cost than the two-option spread. It's an alternative multiple-spread marketing plan. “The way I see it, if you can't live with $5.80 corn or $15 soybeans, don't use this strategy,” explains Hinz. “But both of those price levels are strong, even in today's bullish markets.”

He says that if the ceiling price is approached, a grower may wish to alter the strategy by rolling a price. “I know when growers may face margin calls and advise them of it,” he says.

Broker fees must also be added to the cost. Hinz charges $55/contract to establish a position. He charges $35/contract to take it off.

Hinz notes that with the volatility of both corn and soybean markets — caused by ethanol demand, domestic and international supplies and worldwide demand — prices for both may vary a lot from the prices used in the strategies.

Hurt points out that many local grain buyers offer a contract similar to the window strategy. “They are often called something like ‘mini/max’ contracts for minimum and maximum,” he says. “If the elevator executes the position for the producer, then the options positions must be attached to a cash contract in which the actual cash bushels will be delivered to the elevator.

“In addition, the elevator is responsible for the margin position on the short call option, so the service fee that the elevator charges will have to be higher to account for the costs of the margin position,” Hurt adds.

He says the window is a great strategy with lots of flexibility. “But like any strategy, it has specific characteristics and costs,” says Hurt. “All producers will want to work closely with their marketing advisors or elevator managers to be sure they understand their obligations. They also need to understand how their final returns will vary if subsequent futures prices rise substantially or if they drop sharply.”

Hinz says growers will have to look at where markets are when they decide to use a spread or any options trade, then determine the values of options prices at the time they lock them in.

“Growers should consider protecting a portion of their crops when sky-high prices are available,” Hinz says. “There's a lot of water to run under the bridge between now and fall — don't turn your back on it.”

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