Corn growers penciling out 2021 income projections have a lot to smile about. After years of gloomy prospects, new crop futures translate into profit margins of around 30% for the average producer. That’s double the rate earned by companies in the S&P 500 Index last year.
Still, as I pointed out last week, doing nothing risks turning that profit into a loss if prices or yields stumble enough, even after the government safety net from crop insurance and ARC are deployed. Farmers have myriad tools and strategies for managing that risk, but there’s no one-size-fits-all marketing plan. I looked at 10 other combinations for pricing 2021 corn, and each has strengths as well as weaknesses.
My assumptions: Normal expected yields of 176 bushels per acre and costs of $625 per acre, taking ARC and 80% Revenue Protection coverage. Prices for December futures and options are based on Friday’s close, which put the new crop contract at $4.815. Sales amounted to 80% of expected yield, matching the RP insurance level. Harvest basis varies with prices, assuming tighter basis if tighter supplies produce further rallies and weaker bids if the market falters.
Table 1 looks at the “do nothing” alterative, selling across the scale at harvest. Keeping the upside open has benefits if prices rise. But there’s red ink risk, too, especially if prices fall enough.
Table 2 provides the breakdown for pricing 80% of the crop with futures or hedge-to-arrive cash contracts and relying on RP and ARC for a safety net. It’s hard to come up with a combination of yields and prices that are unprofitable, but $10 corn and 100 bpa yields would do it under this scenario.
Call options are the most straight-forward way of covering risk from rising prices after a sale is made. Calls increase in value if futures rise enough, and these proceeds can be added to the selling price. Table 3 shows the array from covering an 80% sale with at-the-money December $4.80 calls.
The short futures (or cash), long call position is known as a synthetic put because it mimics results from buying a put. This type of option covers some of the downside risk, while leaving room for appreciation if prices rise enough. Results for the long put strategy in Table 4 are similar to Table 3. Using the long call alternative allows more flexibility: the option can be purchased before or after the sale.
The drawback to this strategy is the potential loss that occurs if futures stagnate and yields drop enough. Both types of puts lose money if futures are $4.75 at harvest and yields fall 30 bpa to 146. The challenge is the high cost of at-the-money options. With both futures and implied volatility relatively high, those options cost around 50 cents a bushel. If December futures in late November on options expiration are at $4.80, most or all of the call premium would be lost. The options would hold on to a little of that value at harvest, say, in October, but time value decay could still eat into their value. And revenues would still be higher than ARC or RP triggers.
One potential solution would be to liquidate the call options or roll the puts into a short futures (cash) position once the crop is made in August or early September. That could recover more of the initial premium paid up front for the option but provide less protection against market surprises.
Another alternative is to sell other options. This could lower the cost of the options purchased, but it could also lower the protection offered by the puts or calls. Table 5 shows results from covering a sale with the purchase of a $4.80 call partly financed through the sale of a $5.40 call. Table 6 is what might happen by financing a $4.80 put with the sale of a $4.20 put.
Selling the out-of-the-money call caps gains from the long call when prices rally; selling the out-of-the-money put does the same with put position values if prices fall. The bull call spread, it’s called, provides more downside protection, while the bear put spread fares better if prices keep rising.
The options spreads perform differently than the outright options position because of a factor known as delta. An at-the-money option generally has a delta around .5. That is, it will capture around 50% of the move in the underlying futures contract initially. Selling an out-of-the-money option against this lowers the net delta of the position. The net delta of both spreads is around .32, or about a third of the move in the underlying futures.
There are many other ways of adjusting the cost and resulting delta. Just remember that the delta of a short futures position is -1, then combine this with the net delta of the options position.
One way to lower the options premium is to buy cheaper, out-of-the-money puts or calls. These provide less protection due to their lower deltas. Table 7 and Table 8 show results from using this approach.
Another way to manipulate the delta is through covered puts – in Table 9, selling an out-of-the-money put against a short futures (cash) position. Selling the $4.20 put makes this option’s delta positive. The premium earned provides some upside protection if prices keep rising and adds to the selling price if the option expires with futures above $4.20.
The delta of the $4.20 put is modest, around 15%, but provides protection against lower yields or prices when combined with RP and ARC. Compare these results to Table 10, selling an out-of-the-money call to defray some of the cost to purchase an at-the-money put, a strategy known as a collar. With this collar the deltas of the two positions are added together, providing more downside protection. Table 11 shows even more fine tuning, combining the collar with a short out-of-the money put.
These are only a few of the dozens of strategies farmers can use. Using short-dated new crop options lowers cost at the expense of expirations that occur before harvest. Futures spreads are another tool, though they carry their own risk.
It’s crucial to understand the limits of trying to forecast how any position will fare. Basis can be hard to anticipate, changing due to non-price factors like transportation bottlenecks or excessive speculation that disconnects cash from futures. Changes in implied volatility likewise have an impact, especially during times of very weak or very strong markets. The number of days until expiration will also change options values and deltas, and this year rising interest rates could come into play as well.
So however you do your estimates, remember they’re just estimates. But knowing how a position may perform can make you a more effective marketer, helping you decide which tools work best for your own business.