Strategies for Cutting Options Costs
Aug 21, 2009
In my previous post I outlined a good, basic marketing strategy to follow. I talked about how buying put and call options offers peace of mind against market volatility.
I received a few comments from readers about the cost of options. Allow me to expand a bit on the effective use of options, and why I believe using them wisely serves the producer’s best interest.
First, in this day and age, it is important to recognize that the staying power, effectiveness and peace of mind options offer are well worth the cost. I insure my house and my car to be sure that I am not at risk of financial loss. My house insurance is probably double or triple what it was 8 years ago. But I insure my house, because if it burns down, I'd be bankrupt if I had no house and still had to pay a mortgage. That's why banks require people to have insurance on a car loan. They want to be able to get their money back if you wreck the car.
Same thing applies with commodity markets. When prices collapsed in the last year, $8 corn became $3 or $4 corn. That's like totaling your car and not having insurance. Especially if you bought expensive fertilizer.
Second, it takes knowledge, care and discipline to use options well. They must be managed and executed at the proper time. If you manage them properly, they can perform well for you, and they can be well worth the cost.
Third, there are ways to cut the costs of using options. The most practical way to cut options costs is to use more advanced option strategies such as laddering, bear put spreads, ratio spreads and fences. These strategies take education, effort and--most of all--discipline.
Managing the timing of options also helps cut costs. It’s important to buy the right option and manage it and get out of it before the last 60 days when the option loses its value really quickly. If you buy an $80,000 car, it depreciates at the exact same percentage rate as a $30,000 car. But the dollar amount you're losing on it is phenomenal, because you have $50,000 more losing 20% of its value.
It's the same thing with options. There's a time to buy the expensive one; there's a time to buy a cheap one; there's a time to buy a far-away one; there's a time to buy a nearby one. Those decisions are all instrumental in the success of your program. Being covered and insured when you need it, and not being left out in the cold when you need to have coverage, is key. That goes back to knowledge and discipline and execution of the proper tools at the proper time.
EXAMPLE OF AN ADVANCED OPTION STRATEGY TO CUT COSTS: Let's say you have 80 percent of your old crop priced. If there is an early frost and prices make a substantial rally, you are not going to capture a significant part of that price improvement when you only have ownership of 20 percent of your entire crop.
Buying out-of-the-money distant call options can work to achieve reownership. You can ladder your purchases by varying the strike prices of the call options that you buy, by buying some that are closer to the current market (in the money) and some options that are further away from the current market (out of the money). The more expensive in-the-money options will give you greater leverage and respond quicker to market moves, but cost more. Larger quantities of out-of-the-money cheaper options will have less impact for small price moves, but will hedge you against any major significant upward price move that occurs.
You also can ladder your option purchases by spreading them out over a number of months. Possibly start with call options toward the July contract and then spread them further out into the new crop contract such as December. By spreading the time frame around, you can save some money with the more nearby options; however, you also have greater risk that you will run out of time and they will expire worthless.
One key point about laddering options: If all of the work and decision-making overwhelms you to the point that you don’t make a decision, you will not succeed. As with buying machinery, it takes extra time and effort to be a smart option shopper. If you don’t have the time or discipline to be an expert, you need to hire one.
“Ah, yes,” you may be saying. “I tried working with an advisor and I lost money using options.”
I understand that many producers have had experiences with advisors that have led to frustration. I am willing to bet that those poor experiences were the result of an advisor who based his or her advice on market outlook and not on a solid, strategic approach. (If you missed earlier installments of my blog where I talk about this key principle, you may want to look back in the archives.)
I would not preach the value of using options if I did not believe they could be used effectively and well to give producers as much protection and opportunity as possible. Two facts from our own consulting client base give me confidence in the value of options:
- Our consulting team uses options consistently, to the tune of thousands of contracts per year. The combined result for all of our consulting clients, over a 5-year time period (2004-2008 calendar years), was a positive return on their hedging accounts for both corn and soybeans. This is after all commissions and fees are paid.
- We have a 95.9% renewal rate for our consulting services.
I wanted to share these facts to back up my opinion that options are a necessity for today’s successful marketer. The approach I outlined does indeed serve the best interest of producers.
Scott Stewart is president and CEO of Stewart-Peterson, a commodity marketing education and consulting firm based in West Bend, Wis. You may reach Scott at 800-334-9779 or email him at email@example.com.