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 email@example.com.