If you’re reluctant to use options on futures, there’s a way to use them to protect short-term prices without facing sky-high premium costs. It may be just the tool to hedge against a critical crop report or other issue that can ruin a rally.
Short-dated new crop options (SDNC), available since mid-2012 from the CME Group, Chicago, Ill., provide a short-term alternative for trading new-crop corn and soybeans as well as hard red winter wheat and soft red winter wheat. CME reports that more than 2.5 million SDNC contracts have been used.
The primary difference between SDNC and standard options is that SDNC options expire at various points throughout the growing season, earlier than standard new-crop options. However, they are tied to a longer-dated, new-crop futures contract.
“SDNC options tend to be most actively used by farmers and other market participants during the spring and summer months,” says Steve Stasys, director of agricultural products with the CME Group. “What makes these products unique is that they provide a short-term alternative for trading new-crop corn, soybeans and wheat.
“These options reference the new-crop month, but because they expire earlier than the traditional new crop options, their premiums are typically lower. As a result, individuals can use them to manage their new-crop price risk around shorter-term events such as planting intentions, crop emergence or pollination.”
For an SDNC, an at-the-money premium may be 10-15 cents per bushel, compared to 30-50 cents for a standard at-the-money option.
Chris Hurt, Purdue University Extension ag economist, says SDNC options offer an opportunity to manage price risk more efficiently. “They are lower-cost option premiums than the regular option contracts,” Hurt says. “This is not because of some magic; rather, SDNC premiums are less because one is buying price insurance, or price protection, for fewer days.
“This is no different than buying vehicle insurance for one month versus six months. The insurance coverage is the same, but the premium for one month is less than the premium for six months.”
He notes that SDNC options enable farmers to protect prices during more volatile times of the year, such as during planting, pollination and heading into harvest. The options also offer a way to hedge a price in preparation for negative crop production reports.
Terry Roggensack, grain and livestock marketing analyst for The Hightower Report in Chicago, says SDNC options are another tool for farmers who see a need for better risk management to protect high input costs. “These can be really helpful when you just need protection for a short period of time, such as at the planting season, ahead of harvest or some other situation,” he says.
Set a crop insurance floor
Stasys says another popular use for SDNC options is to mitigate risk around crop insurance. Hurt says SDNC options may be a good tool for farmers to establish a floor on their crop insurance, the price for which is set in February based on December futures prices for corn and November futures for soybeans.
“Say on Feb. 1, farmers feel that new-crop December corn futures are favorable, and they would like to establish a floor price on the new-crop December 2015 futures for crop insurance,” he says. “Their vulnerability is that new-crop December futures prices drop during the month of February as the crop insurance price guarantee is being established.
“Their strategy for 2015 would be to buy a short-dated, new-crop December ‘15 futures put option, say, with a $4 per-bushel strike price for expiration in March ‘15. That gives them roughly 25 days of protection in which they have a minimum December ‘15 futures price established at $4.
“If the December ‘15 futures price drops during the month of February as the crop insurance price guarantee is being established, their crop insurance price is less. But their put option premium increases to help cover the lower crop insurance price. If December futures go up during February, they gain a higher insurance price for their coverage and can only lose the amount they invested in their option premium.”
As an example of lower premium costs for SDNC options, Hurt says the short-dated option premium for March expiration might be 10-12 cents, while the regular December option might be 40 cents. “While the regular option has a higher initial premium cost, it would still have a positive premium at the end of February and could be sold for that remaining value,” he notes.
Stasys says another strategy for price protection would have a farmer purchase a March $3.80 SDNC put option for coverage against an adverse down move in the near term for around 9 cents with December futures around $4. “This covers the farmer for the next 80 days,” he says.
“Looking at a standard December $3.80 put option, the cost would be around 27 cents. If a farmer’s price risk is concentrated in the first quarter of the year, a SDNC option would be a cost-effective tool for price insurance on the new-crop contract.”
Hurt points out that farmers really like the idea of knowing their maximum costs. “They might select the strategy in which the most they could lose is 10-12 cents, versus the regular option,” he says. “The regular option premium puts your costs at around 10 cents a bushel, but it could be up to the full 40 cents a bushel depending on what happens to market price between Feb. 1 and near the end of February.”
Stasys says grain merchandisers at local elevators or terminals can offer their farmer customers minimum price contracts, which are based on SDNC options and offer lower time value and lower premium than minimum price contracts based on standard options.
He adds that with volatile grain markets, farmers may consider using SDNC and standard options to manage short- and long-term risk. “Working with a grain marketing advisor or broker, producers can develop grain marketing strategies using SDNC and standard options,” he says.
“They can take advantage of the different premiums, at-the-money volatility and lengths of coverage to best suit their hedging needs.”