Strategies for reducing premiums in 2013
Options are a powerful tool providing insurance on both sides of the market, but not necessarily the way some have used them. "Options work best when owned for a relatively short time combined with a relatively large price movement," says Frayne Olson, a North Dakota State University ag economist.
"Options work best when owned for a relatively short time period combined with a relatively large price movement."
However, purchasing and owning options for the life of the underlying futures contract can prove expensive. "Farmers often overlook that options contracts can be offset, or re-traded, at any
time," Olson explains, admitting that he’s a bit of a contrarian when it comes to options.
Many experts support long-term ownership of options contracts for price protection, he says. Olson acknowledges that his suggestions on use of options are not for everybody, and require a higher knowledge base. Furthermore, he does not dispute holding options for the duration of the contract if that’s in a producer’s comfort level. (For other views about options, turn to page 30.)
The idea behind owning shorter term options is to purchase "price insurance" against specific market events. "If the event occurs, the option will increase in value and gains can be captured when the option is sold," Olson says. "If the event doesn’t occur, the option can be re-traded, which can reduce the cost of ownership."
Short Term Strategies. For 2013, Olson sees several options strategies that could work well, but these should be individualized. For starters, it’s important for producers to look at their upcoming market concerns.
"Another strategy that offers promise this year for corn and soybeans is buying out-of-the money puts to protect production costs."
For example, if a farmer has un-priced corn in storage and is concerned that the March 28 Prospective Plantings report could result in lower corn prices, he could buy a put option now and sell it several days after the report is released, Olson says. If the report results in lower prices, the put option will increase in value and compensate for the decrease in value. If the report is price neutral or positive, the option can be re-traded—likely at little cost.
Farmers concerned about another drought year and its impact on prices could buy an option in April and sell it in May or June when crop conditions are better understood, Olson explains. In his view, both these strategies make sense for 2013.
"The longer you hold an option, the more expensive it becomes," he says. "Additionally, the longer you hold an option, the less value it has for potential resale."
For new crop corn, Olson says farmers are projected to plant 97 to 100 million acres. "Big acreage and good yields will lead to lower prices," he says, adding that the current soil moisture conditions leave questions about yield potential. Weather forecasts will be followed all summer and add a high level of price volatility.
You can buy a put option to protect against lower prices while owning grain, or sell the grain and buy a call option to capture higher prices. Either provides an opportunity for higher prices.
"Many farmers hesitate to forward contract too many bushels during summer price rallies because they are concerned they will not produce enough bushels to meet the delivery requirement," Olson says. Buying a put option during a summer rally can add price protection against lower prices without requiring delivery.
Olson sees possibilities for using options for wheat, too. During March and April, the extent of potential winterkill damage and the general condition of the winter wheat crop will become known. The wheat market still has a "wait and see" attitude about yield potential, he says. Buying a call option now allows producers to participate in a weather rally this spring, Olson explains. If a rally doesn’t happen, because winter wheat conditions improve, the option can be re-sold.
After talking with producers about their use of options, Olson finds that many are frustrated because they buy options for a hefty premium and hold them for the duration of the futures contract, and then they expire worthless.
Buying and selling an option short term has less risk than selling a call option to cover the cost of a put, which some advocate as a way to cheapen up options, Olson says.
Another strategy that offers promise this year for corn and soybeans is buying out-of-the money puts to protect production costs, says Chad Hart, an Iowa State University ag economist.
"Now is a good time to look at new crop options," Hart says. For instance, December 2013 corn futures were roughly $5.80 last month. With typical production costs of $4.50 per acre, an option with a $4.90 strike price might cost as little as 15¢ per bushel, a cheap guarantee against prices falling below production costs. An in-the-money put near $5.90, however, runs about 55¢, pretty rich, in Hart’s view. An out-of-the money strategy also gives farmers an unlimited price ceiling should weather continue to be dry.
Cutting Soybean Premiums. Hart sees a similar strategy for soybeans. Average production costs for Iowa producers run about $11 per bushel. November 2013 soybeans were about $13.50 per bushel last month. An in-the-money put is running close to $1 per bushel, a hefty insurance premium. Conversely, an out-of-the money put at $11.60 is only 30¢, again, a hedge against prices dipping below production costs that Hart thinks producers should be most concerned about.
On old crop, with May futures of $14.80, which they were last month, it only costs 3¢ per bushel to protect against a price crash with an out-of-the money $12 May put. Moreover, upside protection on beans can be accomplished with a $15.30 call for 20¢. For corn, a $7.80 call is 12¢, again, providing upside protection.
"However, you want options to expire worthless," Hart explains. "That means the market is holding prices above your target level." In the same way you don’t really want your auto or life insurance to pay out, you don’t want options to pay out. "It means the market is ruling in your favor," he says.
"Futures have to move for an option to have value," Olson says. If the event or time period you’re protecting against ends, such as conditions in South America, sell the option, he says. "You can buy another option for the next event you’re concerned about." Olson says it might make sense to own them for a few days, as a hedge against a market report or another specific event.
That might cost pennies, he says. Another period that he thinks options offer potential for options value is during corn pollination. For soybeans, it’s the pod-filling stage in August that producers should be most concerned about. "But you don’t need to hold them to expiration."
Hold Options for Short or Long Term?
There are both pros and cons of short-term versus long-term options strategies. One benefit of a long-term strategy is farmers can implement the options strategy and leave it in place for an extended period of time, without spending a lot of time watching the markets, says Frayne Olson, a North Dakota State University ag economist.
The disadvantage is the cost of the premium. This motivates some to sell options to reduce the cost, such as selling a call to reduce the cost of a put, Olson explains.
Short-term options strategies take more time for farmers to monitor the markets and buy or sell during key time periods or events, he says. "However, the net cost of the option’s position(s) can be lower. So it really depends on how much time and effort farmers want to spend monitoring market positions," he adds.