Grain Price Options Fence
During periods of high prices, farmers are often interested in forward pricing crops. However, many are concerned about using forward cash contracts, hedge-to-arrive contracts, or hedging for fear that prices may go even higher. Buying put options would relieve these worries. But premiums to buy puts rise sharply as prices become more volatile.
Building a fence
Building a fence by using options is an alternative you might want to consider. By building a fence around your net price, you set a minimum price under which the price cannot fall and a maximum price over which the net price cannot rise. To build a fence you buy a put option with a strike price just below the current future price and sell (write) a call option with a strike price above the current futures price. The put option establishes a floor price for your grain. The call option establishes a ceiling price. For information on how to use options refer to:
- Information File Grain Price Options Basics
- Information File Options Tool to Reduce Price
- Information File Options Tool to Enhance Price
The cost of the fence is the put option premium plus option trading costs. There may also be interest on margin money for the call option if price rises. However a portion of this cost is offset by the premium you receive from writing the call option.
Minimum selling price
The minimum selling price from the fence is the strike price of the put option, less the net premium cost, less the options trading costs, less the basis.
In the example, the minimum price from the fence is the $10 put strike price, less 88 cents put premium, plus 78 cents call premium, less 5 cents for trading costs, less a 50 cent basis, or $9.35.
Assume November soybean price drops to $7 at harvest and the actual basis is 45 cents. You exercise the put option which places you in the futures market at $10. You buy back that position at $7 for a $3 futures gain. At the same time you sell your cash beans for $6.55 (actual basis is 45 cents under November futures). Add the $3 futures gain, and the 78 cent call premium to the $6.55 cash price. Then subtract the 88 cent put premium and the 5 cent trading cost. The net price is $9.40. The net price is 5 cents higher than expected price ($9.35) because the basis is 5 cents smaller than expected.
The results would be about the same if you sold your put option to someone else rather than exercising it. The call option will expire worthless.
Maximum selling price
The maximum selling price from the fence is the strike price of the call, less the put premium, plus the call premium, less option trading costs, less the basis.
Assume at harvest November soybean futures price is $12.50. Cash beans rise to $11.90. The actual basis is 60 cents under November. The $10.50 strike price call option that you sold (wrote) is now worth $2.00 (premium) to the call option buyer. So, the option may be exercised by the call option buyer. If so, you have to sell the buyer November futures for $10.50 and buy back the position for $12.50 for a $2.00 loss. The results would be about the same if you bought the call option back for a loss.
You sell your cash beans for $11.90. After making the adjustments the net price is $9.75. That’s 10 cents less than the maximum expected selling price because basis is 10 cents wider than projected. The put option expires worthless.
Below are minimum and maximum selling prices at various put and call strike prices.
Remember, if you’re writing call options and the market goes up, you have margin calls. The increased value of the crop offsets the margin calls. However, you need to pay the margin calls before you receive cash from the sale of the grain. So you need to make arrangements with your lender to cover margin calls.