Updated April, 2022
File A2-69

Crop 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 the following Ag Decision Maker Information Files:

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.

example

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 Example 2, the minimum price from the fence is the $14.00 put strike price, plus the $.78 call premium, less the $.88 put premium, minus $.05 for trading costs, plus a $−.50 basis, or $13.35.

example

Assume November soybean price drops to $11.00 at harvest and the actual basis is $-.45. You exercise the put option which places you in the futures market at $14.00. You buy back that position at $11.00 for a $3.00 futures gain. At the same time, you sell your cash beans for $10.55 (actual basis is $-.45 under November futures). Add the $3.00 futures gain, and the $.78 call premium to the $10.55 cash price. Then subtract the $.88 put premium and the $.05 trading cost. The net price is $13.40. The net price is $.05 higher than expected price ($13.35) because the basis is $.05 narrower than expected.

example

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.

example

Assume at harvest November soybean futures price is $16.50. Cash beans rise to $15.90. The actual basis is $-.60 under November.  The $14.50 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 $14.50and buy back the position for $16.50 for a $2.00 loss. The results would be about the same if you bought the call option back for a loss.

example

You sell your cash beans for $15.90. After making the adjustments the net price is $13.75. That’s $-10 less than the maximum expected selling price because basis is $.10 wider than projected. The put option expires worthless.

Example 6 shows minimum and maximum selling prices at various put and call strike prices.

example 6

Keep in mind, if you are 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. Any interest costs associated with margin calls will reduce your net price.

 

Kelvin Leibold, retired extension farm management specialist, agdm@iastate.edu
Original author:
Don Hofstrand, retired extension agricultural business specialist, agdm@iastate.edu

Author

Kelvin Leibold

retired farm management specialist
View more from this author
Original author:

Author

Don Hofstrand

retired extension agricultural business specialist
View more from this author