Many believe that we are in a golden age of farming in this country. Since the summer of 2006, we have seen grain prices move in a big range, both up and down. These price fluctuations combined with below trend yields, new markets (such as China) becoming more willing buyers, and other policy factors have resulted in farmland selling for increasingly higher prices. After years of battling low prices, the people involved in the farming business feel like they are finally catching a break and beginning to win. Even famous venture capitalist Jim Rogers has become a prophet, touting the virtues of farm products. “If you want to get rich, don’t go into investment banking. Instead, become a farmer.”
However, this boom has drawn a couple of unwanted side effects. Higher input costs and wild volatility in the markets have replaced perennial fear of selling 2.00 corn that farmers are used to. Producers and individuals who have interest in grain prices need to be as nimble as ever to not only lock in these high prices, but also allow them to move higher to match the increasing costs of their inputs. Yet, the most prudent farmers won’t assume these high prices are here to stay. Option strategies like the collar will help protect them from the downside and hopefully keep them in the business for years to come.
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A bear collar is an option position that consists of buying a call and selling a put at different strikes simultaneously. This strategy can help protect producers or long term holders of any commodity from the price falling for a certain amount of time. Most often, the goal of entering into a collar option strategy for hedging purposes is to offset the cost of the premium for the put that you are purchasing by selling a call. If an investor or producer is able to completely offset the premium from the option that is purchased, the collar is referred to as a costless collar, leaving the participant with an insurance position that is free of an upfront cash investment (margin would still be applied).
Let’s look at a live example:
Bill is a corn farmer on a tiny farm in Iowa. At the end of this crop year, he yielded 5000 bushels of corn. He decides to store the bushels on his farm with hopes that he can sell them for higher prices. He believes that over the next 3 months, he will see corn appreciate after the post-harvest price pressures subside. Because he decided against selling the harvested corn after getting it out of the ground, he is long corn (makes money as corn prices go up, loses when they fall). Bill wants to make sure he has some insurance in case the price will move lower but wants to employ a strategy that will not require a large upfront cost. The collar is a fit for him in this situation.
As of right now, Corn for March delivery is trading for 6.35. Bill wants to make sure he is insured below 6.00, so he will look to buy the 6.00 put for 20 cents, or $1000 dollars. This option will provide him protection for the next 100 days. However, Bill doesn’t want to spend $1000 on the put out-of-pocket so he will look to sell a March Corn call at some price over the market. Because Bill will sell a call, he can take the premium received from that call and use it to pay for the price of the put. Bill will call his Daniels Trading broker as a start to look for a call to sell. After evaluating the situation with his broker, Bill decides to sell a 7.00 call on the March Corn contract. He feels that selling his 5000 bushels of corn at 7.00 would satisfy his goals that he set at the beginning of the growing season. Bill looks to the market and decides that he will accept the 7.00 call price of 19 cents ($1950). He will take the 19 cents received from the 7.00 call and apply it toward the put he bought at 6.00 for 20 cents. Should the price of corn in 100 days be above 6.00 and below 7.00, the collar he has will expire worthless and will be out only 1 cent, or $50 plus fees. Should the market expire below 6.00, Bill will be insured due to the ownership of the 6.00 put. If the market for corn expires over 7.00, Bill will be required to deliver 5000 bushels of corn at a price of 7.00 (or simply exit the short call with a loss, offsetting any gains over 7.00).
By setting up the collar, a producer forgoes any profit should the corn price appreciate beyond the strike price of the call written. In return, however, maximum downside protection is in place. This kind of trade can be applied to any position that will be held for a medium to long period of time, such as stocks or bond holdings along with any producer of any good that trades on an exchange.
For more information on how a collar can help you, contact a Daniels Trading broker at 1.800.800.3840.