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August 2009 Archive for Marketing Strategy

RSS By: Scott Stewart, AgWeb.com

Marketing Strategy

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 scotts@stewart-peterson.com.

What is a Good, Basic Strategy to Follow?

Aug 06, 2009
I’ve consistently written about taking a strategic approach and why it’s better than an outlook-based approach. Some readers probably want a more concrete example of what I mean by this. I’d like to give you an example of a good, basic strategy for corn and beans, based on my years of coaching experience.
 
A Basic Strategy Example:
Start by pricing one third of your crop when you start to plant, one third of your crop when you finish planting, and another one-third of the crop around the 4th of July. For a number of years, I coached producers to do this… Simply start more forward contracting earlier to improve their pricing.
 
I heard concerns, though, from producers who didn’t like the idea of having so much under contract before they were certain about the size of crop they would harvest. So I offered an additional suggestion: When you reach your comfortable level for forward contracting, then buy put options on the remainder of the bushels you need to get priced.  (Puts give you the right to a short futures position. They lock in a floor price.)
 
Another reason growers are afraid to forward contract is that they are concerned they will lock in at a low price when prices might get substantially better. This is especially true after prices have been to historically high levels, like 2008, for example. When you leave money on the table, you swear you are never going to do that again.
 
Over the years, I have seen more and more of a hesitation to forward contract due to fears of overpricing. As a result, I began advising growers to look at buying call options against the forward contract sales they had either made or anticipated making. This would give them the confidence to pull the trigger to lock in a price, yet still leave the upside open. By buying puts, forward contracting and buying call options in concert, a producer could be priced if the market went down, and open to take advantage of a price rally, should it occur. (Calls give you the right to a long futures position. They lock in a maximum price.)
 
To recap: Let’s say you forward contract 50 percent of your crop during the winter and spring before you plant, and you buy puts on 50 percent of the crop during that same time window. You are 100 percent covered on that crop if prices go downward. At the same time, let’s say that you buy calls to cover 50 percent of your crop. Those calls offset the forward contracts you placed on 50 percent of the expected crop. If prices go sky-high, the gains on the calls will offset the majority of what was given up by having forward contracted at a lower price level. At the same time, the puts you bought on half the crop would more than likely become worthless, but you would have that crop available to price at the substantially higher price levels, should they occur. You are priced in a down market and positioned to take advantage of an up market. What more could you ask for?
 
This strategy manages downside risk, and at the same time, it manages upward price opportunities. Flexibility is built in.
 
Of course, as you likely have learned in life, nothing is ever perfect. The strategy outlined above works well in any market that has volatility. In a sideways market, the puts and calls will lose money and actually give you a net lower cash selling price than if you had done nothing. Ask yourself this: How often are prices stagnant? Not often! That’s why I believe it is worth giving up a little revenue in a sideways market to put yourself in a position to take advantage of a substantially higher market and to protect against a substantially lower market.
 
Is it worth the cost?
Buying call options year-in and year-out is kind of an expensive undertaking when, in the majority of years, prices go down and the calls become worthless. If you buy calls every year over 10 years, you would spend a lot buying calls. But when you finally have a bull market, you would probably more than make back all the money you had ever spent to protect against risk and secure opportunity.
 
This is a good, basic marketing program for starters. More sophisticated strategies can improve it. I’ll talk about ways to reduce options costs, as well as how to manage the timing of these decisions, in later posts.
 
I hope this example illustrates the difference between a strategic and an outlook-based approach to market decision making.
 
Scott Stewart is president and CEO of Stewart-Peterson, a commodity marketing education and advisory firm based in West Bend, Wis. You may reach Scott at 800-334-9779 or email him at scotts@stewart-peterson.com.
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