In economics, a price floor is defined as a minimum cost threshold put in place for a good or service. For agencies and governments, enacting a price floor can be a tricky business because it involves foregoing open market forces in favor of static valuations. Currency pegs, commodity prices, and minimum wage guidelines are historic examples of price floors.
By comparison, active traders and producers frequently apply the concept to risk management. One way to limit downside market risk via a price floor is through the use of bear spreads.
What Are Bear Spreads?
Among the primary advantages to trading futures and options is the wide range of strategies available to traders. Bear spreads are short-side trading strategies, meaning they generate profits from falling asset prices.
Using futures and options bear spreads, there are many ways for you to profit from a market downturn or to protect market share. The exact structure of each spread varies depending upon asset class, available resources, and trader preference. Here are two of the most common ways of executing a bear spread strategy using futures and options:
|Outright Futures||Simultaneously sell a near-month contract and buy a deferred-month contract of the same product.|
|Options on Futures||Buy out-of-the-money put options in conjunction with an outstanding long position in the futures or cash markets.|
When it comes to building a price floor using bear spreads, options on futures offer superior functionality. For only the cost of a premium, buying a put option allows a trader to lock in a specific strike price, which serves as the floor. In the event the market falls beneath strike, the trade becomes profitable and losses from any outstanding long positions are mitigated.
Price Floors in Action
Implementing bear spreads is one way that agricultural producers hedge against downside risk. By buying out-of-the-money put options, traders can establish a minimum harvest price. Other hedging mechanisms—such as selling outright futures—are also common, but put options offer greater capital efficiency.
To illustrate the functionality of a put option price floor, assume that Sandy the soybean farmer expects bean prices to drop near harvest time. By taking the following steps, Sandy establishes a bottom using put options:
- During early May planting, Sandy buys 25 out-of-the-money put options of November soybean futures.
- The put options have a strike price of $8.50 per bushel, below the current futures market price of $9.05 per bushel. Buying the $8.50 puts carries a 25-cent premium.
- Sandy expects the basis (difference between the cash and futures price) to be near 25 cents per bushel come harvest time in October. When added to the 25-cent option premium, Sandy has built a price floor for the upcoming soybean harvest at $8.00 per bushel.
In the event that soybean prices plummet because of a bumper crop or unexpected tariffs, Sandy is covered. The use of bear spreads has essentially locked in a price floor at $8.00 per bushel. A plunge below the strike price minus the basis and premium ($8.50 – $0.25 – $0.25 = $8.00) will generate gains that offset losses taken on the cash market.
Getting Started with Futures and Options
At first, hedging strategies that involve derivatives products can seem convoluted and overly complex. However, through some study and a conversation with a futures and options professional, you can easily boost your risk management skills.
To learn more about spreads and many other trading strategies, check out the online hedging portal at Daniels Trading. The portal features current market analysis and expert guidance, and the Daniels team can help you build a fully customized marketing plan.