Options Tools to Reduce Price Risk
Price options for grain, when used in conjunction with cash sales, provide a set of marketing tools for farmers. Two of these tools can protect you from falling prices while allowing you to follow prices higher.
For more information on options read:
- Information File Grain Price Options Basics
- Information File Options Tool to Enhance Price
- Information File Grain Price Options Fence.
To successfully use these tools, you must carefully coordinate the use of options with cash grain sales. Using options independently of cash sales results in speculation.
Buying options allows you to establish a minimum or floor price for your grain while receiving the benefits of higher prices. For this price protection you pay a premium. Your decision is to assess whether the price protection is worth the cost of the premium.
There are two basic tools for establishing a minimum or floor price for your grain. One tool involves holding your grain unpriced and buying put options. The other involves selling or otherwise establishing a price for your grain and buying call options.
Using Put Options for Price Protection
You can make money on a put option when the futures price falls below the strike price. As the futures price drops below the strike price, it’s advantageous for you to exercise the option which places you in the futures market, selling futures at the strike price. Then you buy the future contract back at the lower futures price and pocket the difference.
If you don’t want to exercise the option you can simply sell the option in the options market. You will make at least as much money by selling the option as you will by exercising the option and buying back the futures position.
As shown in Figure 1, the farther the futures price drops below the strike price, the more the put option increases in value. However, as the futures price declines, the cash price also declines. So, as the put option increases in value, the value of your grain decreases due to the declining cash price. A floor price is established because the gain on the put option offsets the decrease in value of the cash grain.
The strike price sets the floor futures price because this is the point at which the option begins to accrue exercise value which offsets the declining value of the cash grain.
To translate this into a floor price for cash grain, you must estimate what the cash price will be when the futures price reaches the strike price. Do this by subtracting the expected basis from the strike price. This is the basis you expect will exist when you plan to sell the option and the grain.
The net cash floor price is the cash floor price less the put premium and trading costs.
To implement this strategy, purchase the put option now. Later, when the grain is sold, also sell the option. If the price declines, as shown in Figure 2, the money made on the option will offset the loss on the cash grain. If the price rises, the option expires and the cash grain is sold for the higher price, as shown in Figure 3.
As shown in these examples, whenever the futures price is at or below the strike price, the net price is $6.10.
The actual floor price will differ only due to changes in basis, not changes in futures price.
Because the basis is 10 cents narrower, the cash price is 10 cents higher, resulting in a 10 cents higher price than the previous example. The opposite is true if the basis is wider.
If the futures price is above the strike price, the cash grain is sold for the higher price and the option is allowed to expire.
Estimating the Floor Price
An estimate of the minimum net price or floor price can be made in advance. It can be computed by subtracting the premium, expected basis, and trading cost from the strike price.
Using options for price protection turns out to be the second-best alternative regardless of whether price rises or falls. If price rises, the alternative of doing nothing and waiting for the higher price results in the best alternative. If price declines the best alternative is to sell now before the price declines.
As shown in Figure 4, if the price declines, the best alternative is to sell now for $7.00. If price increases, the best alternative is to hold for later sale. If the price stays the same, both the sale now and the hold for later sale alternatives are preferred to the option alternative. In none of the situations did the options alternative result in the highest price.
Reducing the Cost
One of the complaints of using put options to reduce price risk is the high cost of the option premium. One way to reduce the cost is to buy out-of-the- money options. The premiums for these options are less than at-the-money options. Because of the smaller premium, out-of-the-money put options result in a higher net price if price increases. However, out-of-the-money put options result in a lower minimum or floor price.
So, out-of-the-money options result in a lower floor price but a higher net price if price rises.
Using Call Options for Price Protection
The strategy involves selling or establishing a price for your grain and buying a call option. If price rises, you benefit because the call option increases in value similar to what the grain would have increased in value. Your net price is the sale value of the grain, plus the gain on the call option, less the call option premium and trading cost.
To implement this strategy you sell or establish a price for your grain and buy a call option. Later when you normally sell your grain, you sell your call option. If the price has increased above the strike price as shown in Figure 5, you sell your option at the higher price and add it to the sale price of the cash grain. If the price has declined below the strike price as shown in Figure 6, you let the option expire worthless.
As shown in the example below, whenever the futures price is at or below the strike price, the net floor price is $6.10 (not including transaction costs).
If the futures price is above the strike price, the call option is sold and its value is added to the cash sale price.
As the futures price rises above the strike price, the option increases in value resulting in a higher net price.
Calculating the Floor Price
The floor price or minimum price can be figured in advance. It can be computed by subtracting the option premium from the cash sale price. If the futures price drops below the strike price the option will expire worthless.
Reducing the Cost
One way of reducing the cost of the option is to buy out-of-the-money options. The premiums for these options are less than at-the-money options.
Out-of-the-money call options result in a higher floor price. However, out-of-the-money call options result in a lower net selling price if price increases.
So, out-of-the-money options result in a higher floor price but a lower net price if prices rise.