Hedging agricultural crops using options can be a very useful risk management tool if used correctly. The number one focus of any grain producer’s marketing year is to make “cash sales” at the best possible price. However, this is much easier said than done. Why? Because we can’t predict the future. Therefore, savvy producers use the options market to establish price floors and potentially participate in upside price rallies. Let’s review options basics so we can learn how producers can mitigate downside risk and craft strategies around their cash sales.
What is an Option?
There are two types of options: calls and puts. A call option is a financial instrument that increases in value if the commodity increases in price. Technically, a call gives you the right to buy something at a specific pre-determined price (strike price) at any time within a certain time frame (before expiration). A put option works the same way except, it is for the opposite price direction. If the price of a commodity falls, a put option increases in value. A put gives you the right to sell something at a specific pre-determined strike price before expiration.
It is important to understand that every call option has a buyer and seller: a buyer of the call and a seller of the call. Likewise, a put option has a buyer and seller. The key difference is this: buyers are holding the rights held within the option contract and sellers are offering the rights held within the option contract.
For the purpose of this article, we will use a simple example of buying a put option to protect against falling prices (as we get more advanced in our hedging education, we can use a variety of strategies). Option buyers pay a “premium” (cost of the option), and this is the maximum risk exposure we have. It is important to understand that option buyers do not deposit margin so it is not possible to have a “margin call”. This makes buying calls and puts very attractive to grain hedgers; once the options are purchased, there is no additional risk or margin calls to worry about.
Using Options to Protect Against Falling Prices
For example, let’s say corn is trading at $5.00 per bushel. Joe produces 5,000 bushels of corn but is worried about the price falling before he can sell it. He wants to create a “price floor” so if prices do fall, he will be able to sell his corn at a minimum price. His per bushel cost of production this year is $3.00 so he would like to “lock in” a worst case scenario for this year’s crop at $4.70 per bushel. Since he is worried about falling prices, he wants to purchase one put option (each option controls 5,000 bushels). He calls his broker to purchase one corn put option that expires six months in the future and costs him 30 cents or $1,500 before commission and fees (5,000 bushels/contract x $0.30 = $1,500).
Maximum Risk = 30 cents or $1,500 plus commission and fees
Maximum Reward = Unlimited (the further the price falls, the more the option can gain in value)
Given this scenario, the lowest price that Joe may have to sell his corn is $4.70 per bushel. What if grain prices decreased over the six months since purchasing the option? If the price of corn traded at $4.00 per bushel, he would have sold his grain at $4.70 as the value of his put option increases due to falling corn prices ($4.00 per bushel cash sales + $0.70 put option sold = $4.70). Once again, he was able to mitigate risk by owning the put option. If he had not purchased the option, he would have been forced to sell his corn at the lower price. Instead, he was able to protect his downside risk by owning a put option and establish a price floor at $4.70.
What if grain prices increased over the six months since purchasing the option? If the price of corn traded to $6.00 per bushel, he would have sold his grain at $5.70 ($6.00 cash sales – $0.30 put option premium paid). The value of the option would have fell to be worthless as the market rallied higher (remember, the value of put options fall in rising markets). Joe would not be able to sell at $6.00, he had no idea prices would rise over the six months. Remember, we can’t predict the future! However, given his $3.00 per bushel input costs, he has a great year selling his cash grain for a net price of $5.70 per bushel.
We have looked at a basic overview of using options to hedge agricultural prices. While options can be used much more dynamically, the major goal of any producers hedging program is to protect against falling prices before you can sell your cash grain. Purchasing options are a straightforward and non-marginable way to mitigate overall risk.