Scheve: Why I Don't Think Buying Put Options Is Always A Good Decision For My Operation
Nov 19, 2018
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Market Commentary for 11/16/18
The market continues to watch the actions of the President and China. It's hard to know if there will be a trade fix at the G20 meeting in just over a week. I expect a sideways market through the holiday and leading up to the big meeting between world leaders. After the meeting, it's still uncertain, but recent history indicates the market hits its low at the end of November and starts increasing in December.
Why I Don't Think Buying Put Options Is Always A Good Decision For My Operation
The last two weeks I explained why I prefer to sell calls and why I avoid buying calls for my farm operation. But, what about put options?
What Is A “Put” Option?
Buying a put is the right to sell grain at a desired price. Basically it allows a farmer to guarantee a floor price for their grain while leaving unlimited upside potential if the market rallies. When buying a put there is an upfront cost premium, but no risk of margin call.
A Floor Price With Unlimited Upside Potential Sounds Like A Very Safe And Low-Risk Option
With so much uncertainty in farming, like the weather and politics, buying puts on the surface looks like it can help minimize farmer fears of an unpredictable market. However, like all option trades, it's not a perfect solution.
Issue #1 - The Cost Of The Put
When buying a put I have to subtract that cost from the price level I purchase. For example, Dec '19 futures are about $4 right now with a $4 put costing about 25 cents. That means the true floor price for my grain is $3.75 ($4 - $.25 = $3.75).
Most University studies say the average farmer needs $4.20 futures to cover all production costs. So, I'm not interested in protecting a floor price that is 40-50 cents below the average farmers’ breakeven.
Issue #2 - The Value Of A Put Decreases During Market Rallies
If the market rallies over the summer, I'll lose some or all of the premium I paid to buy the put. This isn’t exactly bad because it means the price of grain is going higher and the puts did their job. But just like my floor price is below the price level I buy when I purchase a put, so too then is the higher price I sell after I subtract out my costs for buying and later selling the put.
For example, let's say I bought the $4 put for 25 cents today and then the market rallies to $4.40 in late summer and I sell my grain at that point. Since I no longer need the floor protection the put provides, I should sell it back out to recover as much of the premium I can. However, by then it's value would have likely decreased by 15 cents to about the 10 cent level. Since I still need to take into account the cost of the put, the price of my sold grain is actually $4.25 not $4.40 ($4.40 - $.15 put ownership cost = $4.25). While that's above the average breakeven, it's not by much.
With what we know today, a rally to $4.40 next summer could be unattainable. For the last 2 years the market stalled out between $4.15 - $4.30 over the summer. So, for me it would be a better plan to just sell those values, if they become available, than to buy a put today that provides a floor for well below my breakeven.
To illustrate my point, let's say I buy the $4 put today for the 25 cents and futures rally to $4.20 next summer. If that happened, I could sell corn for $4.20, and then sell back the put, which is now worth likely only 15 cents (10 cents less than the amount purchased). Since I still need to take into account the 10 cent difference, my corn sale at $4.20 is now only worth $4.10. $4.10 is only 10 cents higher than current prices today, so buying the put actually limited my upside potential from the small rally I’m hoping for.
Now if prices fall to $3 next fall, I would want puts in place. But, I not sure $3 is likely, just like I don't think $4.50 is likely with the information I have today. I find it's usually best for me to not get overly greedy hoping for a huge rally with my options strategy and just sell my grain in early and middle summer. This is where its so important to have a sound marketing plan in place and to have a strategy that takes into account a market that could move in any direction.
Is There A Good Time To Buy A Put?
Back in 2011, 2012 and 2013, it was possible to buy put options where the guaranteed price, after the cost of the premium, was above my breakeven point. But since 2013, similar opportunities have been limited.
This year I had some success buying puts about a week or so before a few USDA reports, but the money made and protection levels received were limited. In hindsight, I should have just sold futures instead of trying to cling to hope that prices would go higher.
In looking back at 2018, the best opportunity to buy a put successfully was if a farmer bought a $4 put for 20 cents in mid-May when the market hit it's high for the year at $4.25. However, with that trade the best a farmer would have done was to have a $3.80 floor, because the market only went down right after that. Instead, the better strategy would have been to just sell futures from $4.20 to $4.25, which was at least 40 cents better than clinging to hope with the put strategy.
In my experience, I'm generally better off selling futures when prices rally above the average farmers’ breakeven point instead of trying to buy protection below my cost of production. Ultimately, if the market rallies significantly I have next year's grain to sell that will now be at much higher levels.
What About Selling Puts?
Put option sellers receive a premium upfront in exchange for having to buy grain at a certain level. There could be margin call on this trade if the market fell and this trade would then make the put seller long grain. Typically this type of trade would be done by end users and not grain producers. A producer selling puts would be speculative and would add risk to their operation.
Buying And Selling Put Options Are Not A Perfect Solution
Many in the trade make it seem like buying put options is a perfect solution for farmers, but as detailed above, they are far from perfect and have many limitations. I'm always cautious with the promise of downside protection and unlimited upside potential. In grain marketing there is often a catch when something sounds too good to be true.
The reality when buying puts is that I will usually miss out on opportunities if prices go up, down or sideways. And on the flip side, if I sold a put, I make a little money when the market goes up or stays sideways, but my downside isn't protected and I've added risk to my operation because I could actually have more grain than what I started with that I would have to worry about.
While buying put options can provide another layer of opportunity in a grain marketing strategy, they aren't the perfect solution many in the trade make them out to be. Its why I seldom by puts for my operation.
Interested in similar articles by Jon Scheve? Check out:
Why margin call is a good thing.
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