Re-Owning Corn With Futures Or Options - The Pros And Cons Of Both

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Market Commentary for 10/4/19

Last March the corn market lost 30 cents after the USDA surprisingly increased stock levels. This week the USDA surprised the market again by reducing corn stock levels, resulting in a 20-cent market rally. The reason for the adjustment isn’t clear. Some think it was because last year’s yield was lower while others say more animals were on feed. Regardless, it’s keeping prices from going lower until yields are determined, which won’t be for a month or two.

Corn Re-Ownership Strategies

For the last 2 weeks I’ve described how to choose which crop should be stored at home during harvest and if farmers should pay for commercial storage. When making those storage decisions I explained that futures shouldn’t be included in the evaluation because farmers can re-own grain using futures or an option strategy. While there are countless ways for farmers to re-own grain, the following shows two strategies most often used and the pros and cons of each.

Re-Ownership Using Options - Buying Calls

In this strategy a farmer sells their grain for cash and then buys a March call trying to capture upside potential. Buying a call is buying the right to own grain at a predetermined price called the strike price. This strategy is often recommended because it limits loss potential to an upfront cost (i.e. the cost of the call option) while leaving unlimited upside potential.

While this sounds positive on the surface, there are hidden issues with this strategy. First off, there are numerous variables determining the call’s value:

• How long until the call expires, in this case March options expire Feb 21st
• How close the call is to being “in the money,” which is the difference between the futures value and strike price purchased
• General belief of where the market could be headed or volatility

Following shows how the costs of buying different March call options shifted from before to after this week’s USDA report.

As of the Friday after the report, March futures increased 13 cents; however, the cost/value of the call didn’t increase the same amount. It only increased 4-8 cents depending on the strike price.

A common choice among the above options would have been to sell cash grain at $3.84 futures and buy calls at a $4.00 strike price for 9 cents before the report. However, if the March futures continues to trade at or below $4.00 for the next 5 months, the value of the $4.00 call will probably never exceed the 14-cent value it is today. Without a rally above $4.00, the call will eventually work its way to zero value. The call buyer is then out all of the 9 cents they paid for the option before the report.

Re-Ownership Buying A Futures Contract

The strategy that best resembles what farmers do when storing unpriced grain in a commercial facility is selling cash grain and buying a futures position at the same time. Let’s assume the same scenario above, a farmer sold for cash corn last week and immediately re-owned March futures for $3.84 hoping for a future rally. With $3.97 futures now, the buyer is ahead 13 cents on the trade.

Which Trade Is Better?

Both trades have risk, so the question I would ask is, “what do you expect from the market?” If you expect the market to go higher, buying futures is better because you get 1 for 1 price movement. Buying calls only gets 1 for 2 price movement during the first part of a rally. If you expect the market to tank, buying calls may be the better solution. However, if you really believe prices are going to go much lower, why not also sell more bushels or even sell some corn for a different crop year to minimize the risk of loss on the purchase of the call?

However, the futures buyer will be behind a call buyer, if futures drop below $3.75 in this example. The most a call buyer can lose, in this case, is 9 cents from the trade. If we subtract that value from the $3.84 cash price collected, we are left with the price where the futures buyer or call option are basically at the same breakeven point. However, if the futures prices continue lower, the futures buyer has unlimited downside loss potential. In other words, buying futures does worse than buying calls when the market goes significantly lower than the cost of the call option.

I tend to dislike buying calls because of the odds against them making money. In the 3 possible market scenarios (i.e. up, down or sideways), buying calls will only make money in 1 of the 3 possible outcomes, if the market goes up a lot. Call buyers will lose money in a sideways or lower market. That’s 66% of the time buying calls will not be successful.

Futures buyers, on the other hand, will be more profitable than call buyers in 2 out of 3 market scenarios, or 66% of the time. I also would take into consideration the time of year when deciding between using futures versus calls. Post-harvest prices tend to improve until around July 4th, so buying futures has less risk during this time. Prices tend to drift lower from July 4th to harvest, so buying calls has less risk during late summer.

Re-ownership through buying futures, or buying calls, or even leaving unpriced grain in commercial storage all have risks. And unfortunately, reducing risk means also reducing reward. Everyone has different risk tolerance and profit goals, but it’s important to think through your goals and have a plan. The statement, “I want to make the most I can” is not a satisfactory plan, because it doesn’t provide risk parameters or attainable goals.

Want to read more by Jon Scheve? Check out recent articles:

Should I Pay For Commercial Storage?

Which Is Better For On Farm Storage - Corn Or Beans

How I Roll Contracts Forward To Pick Up Market Carry Premium

Pre-Rally Trades Leave Me Some Sales At $4

13 Variables That Will Affect Market Prices Through Thanksgiving

USDA Acre Estimates Are In - But What Will Final Yield Be

Can This Market Go Back Up?

What We Still Need To Know To Determine Market Price Direction

Jon Scheve
Superior Feed Ingredients, LLC
jon@superiorfeed.com

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