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Corn+Soybean Digest

Riskwise

Sometimes when we suggest using options, the response we get is, "I don't like using options because they're often worthless when they expire." As risk managers we have to get away from the mindset that every time we buy an option it should increase in value.

When a speculator purchases an option, he wants it to increase in value. If it doesn't, he loses money. But for a risk manager, sometimes the best thing that can happen is the option is worthless when it expires.

A risk manager is different than a speculator. Whenever you begin paying for seed, chemicals, fuel, rent and other expenses for your crop, you become "long the market," meaning you own an interest in that crop.

Producers are intrinsically long the market until they sell or lay off that risk. If the market goes down, the value of that future inventory goes down also - unless they have taken steps to manage that risk.

How can you lay off some of that risk? As the market reaches a point where you can cover your costs (costs include payments, operating and living expenses, depreciation and a profit), you could buy a put option. When you buy a put option you lock in a selling price for your grain.

When a speculator buys a put option he only makes a profit if its value increases. As a producer trying to manage risk, you buy the put option to protect your investment and profit.

If the price drops, the put increases in value and offsets the drop in value of your inventory. If the price rises, the value of the put decreases, but your inventory is worth more. If the price increases more than the cost of the put, you gain additional profit. In this case you'll be ahead more if the put is worthless when it expires. As a risk manager you win either way.

Producers need to realize the advantages of the Chicago Board of Trade. Why? Because farmers produce the product and they can use the tools of the board to reduce risk. The danger is in becoming speculators on the board.

Another way to take some of the anxiety, emotion and frustration out of risk management in the previous example is to theoretically run your balance sheet every day after you buy the put. If your put increases in value, then your balance sheet holds its value. (The put increases in value but your inventory value drops.)

If the put decreases in value, your net worth increases as long as your production maintains. Your net worth will go up faster if the put expires worthless if you are a risk manager and not a speculator.

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