Options for Hire

April 4, 2012 07:00 AM
Options for Hire

Producers put on marketing caps

For months now, Scott Friestad has sallied up to the computer in his farm office and stoically punched in numbers for 2012 corn marketing scenarios. He’s not doing this alone. Friestad is partnering with one of his best marketing friends—options. He doesn’t like what his new computer program is showing him. It’s a shock, seeing how much corn’s profit picture has changed in just weeks.

"I haven’t pulled the marketing trigger yet, but I’m thinking I will soon," Friestad says. The Morris, Ill., corn and soybean farmer knows the December corn futures above $5.60 in late winter could drop well over a buck or more by harvest.

"I’ll be selling both puts and calls if it looks like prices are headed lower," Friestad says. He does not advise selling puts without federal crop insurance, however. "I like the fact that with options, you can lock in a price range. They protect you regardless of what the market does."

What Friestad knows for certain is that the options strategies that worked so well last year won’t work in 2012. For last year’s crop, a major part of his strategy involved selling at-the-money options, collecting a $1.60 premium in the process. "So far this year, markets aren’t nearly as volatile, so premiums for a similar move are just $1," he says.

December corn futures could easily drop to the $4 area during the next six months, predicts Bryan Doherty, senior market adviser for Stewart-Peterson. "For most, that’s below the cost of production," he says.

Those don’t have to be your prices, however. Shrewd use of a combination of the following five options strategies for your 2012 corn production can land you prices that are well above the $4 average.

1. Fence. In early spring, December corn futures were about $5.50 per bushel. You protect the downside by purchasing a $5.50 December put for 54¢ and selling a $7 December call for 30¢, thus reducing the put premium to 24¢. If December corn futures at expiration are $3.50, you net $5.26 ($3.50 plus the option value of $1.76).However, if futures rally to $8 at expiration, the corn you used the strategy to protect is worth $6.76 ($8 minus cost of the put and loss on the short call).
Selling the call to cover the put places a cap on the upside, but it would take a serious weather threat throughout the Corn Belt to push corn to $8 in November, the option expiration month, Doherty says. "I think this is a win-win strategy, but if corn rallies, you will have margin calls," he cautions.

2. Calendar Fence. You buy a $5.50 December corn put for 54¢ and sell a May $7.40 call for 15¢. "You have chipped away at the cost of the put option by selling shorter time value, since it’s not expected that corn will rally to $7.40 by April 20, the option expiration," Doherty says. You may also sell July calls at the end of April, attempting to collect additional premium.

3. Short Strangle. You sell an out-of-the-money call and put. You believe the market will remain range-bound. Your goal is to collect a premium. For example, you sell a July $7.50 call at 26¢ and sell a July $5.50 put at 15¢. If the market remains between those prices, you net 41¢ in premiums at expiration.

4. Ratio-Call Spread. This strategy has you selling a lower strike price call and buying multiple out-of-the-money call options. "This has real applicability this year," Doherty says. "The likelihood is that corn prices will go lower, but with such a tight carryover of 800 million bushels, the sky is the limit with weather."

You forward sell corn at $5.50 and implement the ratio-call spread for re-ownership. In addition, sell one December $6 call at 40¢ and buy three December $6.50 calls at 25¢ each.

"You are leveraged three to one in a bull market, but also have downside protection through forward selling," Doherty explains. If corn futures rally to $10, you net $11.65, and if they fall to $4 at expiration, you net $5.15. "You’re prepared for both scenarios of higher or lower corn
values," he says.

5. Ratio-Put Spread. You sell one December $5.50 corn put at 50¢ and buy three December $5.00 corn puts at 22¢ each. You do not forward sell. If, at expiration, futures rally to $8, you net $7.84, but if futures drop from $5.50 to $3.50, you net $7.81. "The $2.34 final option value is the power of this strategy," Doherty says. This is a strategy in which you believe the market will likely go lower, but you want upside potential, just in case growing conditions turn foul.

Time to Get Protection. Rodney Connor, farm marketer with Cargill AgHorizons, says producers are less sold on corn than they typically are as spring rolls around; thus they may want to consider pricing tools based on the value of options, and soon. One hedging strategy he advocates is Cargill’s Minimum Price, which would establish a floor price on a delivery contract with Cargill just below where corn futures prices were sitting in early March.

"This strategy is a great one, but the cost is a bit rich for me," Connor says. "By creating parameters around market participation, I can cheapen that up by about 25¢." He sees two ways to do that. One is to use a short $7 strike call option value, which nets producers a 16¢ premium. If corn goes to $8, the put value is worth nothing, but producers’ cash price equation allows them to participate up to $7. "If corn goes to $4, you are protected at $5.60 less your investment," he says.

Another possible strategy in 2012 is to use the same $5.60 put value and use a short $4.70 strike put option value, which gives farmers unlimited participation to the upside while also protecting the downside to $4.70.

"This, too, cheapens up the investment," Connor says. "Some farmers struggle with these strategies because of the complexity and the risk associated with margining traditional options," he adds. Cargill, however, has embedded options as a pricing mechanism in a cash contract that is tailored to the producer’s needs and requires no margining.

Keep Strategies Simple. Mark Gold, president of Top Third Ag Marketing, argues against making options overly complicated. "It’s like a microwave oven. You don’t need to know all of the physics on how it works in order to use it," he says.

Gold thinks it’s a mistake for producers getting started in options to get bogged down in components of options valuations, such as deltas, betas, etc. He thinks it far better for producers to focus on using long option positions and spend the premium to avoid margin calls.

"I am concerned about selling a call to pay for a put, because farmers may have margin calls," Gold says. Saving 30¢ in premium may not be worth the risk because selling calls can make you emotional due to margin calls. When you get emotional, you may lift the hedge, ending up with $3 corn instead of $8, he says.

"The call option is like a lottery ticket," Gold says. "Eighty-five percent of call options expire worthless, but it may be worth every penny if it gives you the confidence to ‘pull the trigger’ on great cash sales."

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