Know your tools in your toolbox

Published on: 10:16AM Mar 17, 2011

Through my recent travels and various speaking engagements, I've talked with a number of different farmers and heard that some commodity marketing advisors have been recommending approaching the grain markets (corn, soybeans, wheat) with strategies such as fences or collars. A fence and a collar are the same strategy. Basically, what you're doing is buying a put option to protect against the decline in market prices while selling an out-of-the-money call option to collect premium to help pay for the put. An out-of-the-money call option is an option that is above the current market price. A more aggressive approach of this strategy is where you buy one put and sell more than one out-of-the-money call. That way you can buy the put closer to where the current market is and sell the out-of-the-money calls for a small investment or possibly potentially even a credit.

If you pick a top or get into one of these strategies in a declining market that continues to decline, they are a great tool. You'll feel real smart and everything will go wonderfully. However, you should always be aware of the risks using the tools in your approach. In a fence strategy where you're selling two calls, you can get buried big time if the trend continues higher. Even a fence strategy where you're selling only one call can generate margins on the call that can amount to more than most any farmer will want to stomach. Let me give you a little math. Perhaps this is a bit extreme, yet it makes the point.
Let's say you do a fence on corn around the $6.00 area. In this example, you sell two $6.50 calls. Summer brings hot and dry weather, everyone gets fearful that we will not get a good crop and that we will run out of ending stocks. Corn shoots up just past the previous highs and hits $8.50. Those two sold calls lose $5,000 each. That's $2.00 per bushel, or $10,000 per trade. If you did them at $6.50, you'd be looking at $4.50 corn. What do you think the cost of production would be if corn is at $8.50? How would you like to be selling your corn in the low $4s when your neighbors are selling their corn in the $6s, $7s and $8s? This is not a pretty picture.
I'm not saying you shouldn't use a fence. I am saying to do so wisely. If you are looking at doing a fence, I suggest you be a bit more conservative and do a one-to-one; buy one put and sell one call. And then layer in an out-of-the-money bought call option against the sold call. So let's say you're selling a $6.50 call. Perhaps buy a $7.00 call as a hedge against the sold option. It's not perfect, though it can keep you from getting buried.
As an alternative, consider a ratio put spread. In a ratio put spread, you sell a put that is closer to at-the-money and buy multiple out-of-the-money puts. It's a fixed-risk strategy. You know the costs and risks right upfront. Risk is fixed to a range. Maximum risk occurs if futures (at expiration) end at the bought put's strike price. This position provides for high leverage, and if prices move lower you have the potential of multiple long puts working in your favor.  In today's volatile markets, those are really nice features.
I am writing this only to alert you to some of the risks involved in some of the strategies that are being suggested. Some of these strategies were recommended near the most recent top of the market, and today they look pretty good. If you're in them, my suggestion is to use the most recent price break to buy back your sold call or to buy that out-of-the-money call against it to limit your risk. Fixed risk strategies are a big plus when there are nuclear meltdowns, massive political unrest globally and the threats of all sorts of natural disasters looming.
One of the first and most important rules I have with marketing is to avoid doing anything stupid. Another way to say this is to do no harm. You want to make marketing moves that will keep you out of trouble and will help you, and if you're wrong, they will hurt you only a little. Don't make marketing moves that can hurt you substantially. They call it risk management for a reason.
I also believe that a big part of marketing in this day and age is opportunity management. You have to balance the opportunities and the risks. Just be sure you understand the risks and the opportunities of the tools that you're using. If you don't understand them, don't use them.
I always say to either be an expert or hire and expert. In these volatile times, there is little middle ground there. There is massive opportunity, and there can also be massive risk. Don't let it scare you away. You cannot turn your back on it. You have to face it. Face it armed with knowledge and respect. I wish you well. May your marketing be successful.
Scott Stewart is president and CEO of Stewart-Peterson, a commodity marketing consulting firm based in West Bend, Wis. You may reach Scott at 800-334-9779, email him at [email protected].
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