The Case For, and Against Using Options

Some swear by the usefulness of options in grain marketing, while others wouldn’t touch them with a ten-foot pole.  Here, grain marketing experts Ed Usset and Mark Gold each make their case on the pros and cons of using options. Both are well-versed on options and other grain marketing strategies: Usset is a former merchandiser for Pillsbury who currently is a grain marketing specialist for the Center for Farm Financial Management at the University of Minnesota (www.cffm. umn.edu). Gold is a former 20-year member of the Chicago Board of Trade where he was a pit trader and floor broker, who currently is managing director and primary broker of E Hedger Inc., www.ehedger.com .  It’s your call, as we put it, to decide whose assertions are at-the-money.

Mark Gold’s Case For Using Options
American farmers are the best producers of agricultural products in the world. However, their marketing efforts are frequently too little or too late.  As a former 20-year pit trader at the Chicago Board of Trade, it is my opinion that options represent the single best marketing tool for agricultural producers.

An options contract gives a farmer the right, but not the obligation, to buy (with a call option) or sell (with a put option) a specific commodity within a specific period of time at a specific price. With options, farmers can establish a minimum selling price for their crops or livestock, while still retaining the right to any price increase.

Here’s a simple illustration of how an options contract works, courtesy of the University of Nebraska.  Consider a call option that conveys the right to purchase a used tractor from your neighbor. You are debating whether to buy a used tractor or to put up the capital for a new tractor. You persuade the neighbor to sell you an option to purchase the tractor at any time before December 15. In turn, the neighbor gives you the right to buy the used tractor for $5,000. For this right, you pay $1,500.

In options terms, the tractor is the underlying commodity, and $5,000 is the strike price. Dec. 15 is the expiration day, and the $1,500 you paid for the option is the premium.

Prior to the expiration date, your option contract gives you the right, but not the obligation, to exercise your option and purchase the tractor. However, you are not obligated to buy the tractor.  A better deal on a tractor may come along, so you may choose to not exercise your option, or simply let your option expire. You may offset your current position by selling your option to someone else. Whatever measure you take, the writer or seller of the option, keeps the $1,500 premium.

The biggest problem for producers to overcome is that they expect to make money on their put options.  Producers should view and should use a put option like an insurance policy. Like any insurance policy, you pay a premium to protect you from a catastrophe. Like any insurance policy, you don’t want to collect on the policy, and you expect to lose the premium. It’s exactly the same with a put option. We know that 85% of options expire worthless.  We want our puts to expire worthless.  It’s there in case price goes down, but you would prefer to see $3/bu corn and $7/bu beans and lose the premium. 

The major benefit of buying options is no margin calls.  What you pay for the option plus the commission and fees is your only risk. Buying options also gives you the benefit of time.  For example, buy a Dec $3.40 wheat put in January or February and carry it for the next 10-11 months. You can go out and plant your crop, spray, cultivate, fix machinery, watch your kids little league or soccer games, knowing that every second of every day you have a floor under your prices.  Should prices go higher, great! If prices collapse, then you’re better protected.  You can sleep better at night knowing that you have already locked in a minimum price of $3.40 for your contracted bushels.

I work with agricultural lenders from across the country and many are willing to lend money for options because the producer can protect the bottom line without any margin call liability. A put option protects the downside but allows you to participate if the market rallies.

Not only can options help protect you from a price collapse, they also can help you take advantage of higher prices.  You and I both know that farmers can be reluctant to “pull the trigger” on cash sales.  However, go ahead and sell grain on a rally on a flat price or a significant improvement on the basis. You can always replace those sales with call options if you are concerned about missing out on higher prices.  When buying call options, you do want to make money on the option but we know the odds are generally against you. Even so, if it helps you sell cash grain on rallies and save on storage costs, I feel it is usually better than hoping for higher prices or storing grain.

Back to our tractor analogy; can you imagine being without one?  It makes farming easier, more efficient, and more profitable. If you didn’t know how to operate that machine properly, however, it could make your farming harder, less efficient, and less profitable. Same with options. Once you learn about options, or work with a grain marketing advisor/broker to use them, I believe you will find them to be an invaluable tool to help manage price risk. 

Ed Usset’s Case Against Using Options
Since their re-introduction in the early 1980’s as a trading tool for agricultural commodities, options have been widely touted as a great pricing alternative for grain and livestock producers. The advantages of options are repeated often;
(1) buying options to establish a minimum price affords the seller protection against lower prices while retaining the opportunity to benefit from higher prices,
(2) for option buyers the “cost” of the hedge is known upfront, and they avoid the dreaded margin call, and
(3) the hedging strategies available are almost countless based on the myriad of combinations of buying and selling options.

In my work as grain marketing specialist for the Center for Farm Financial Management at the University of Minnesota, I’ve talked with over a thousand producers about grain marketing plans and pricing strategies. As a rule, I find that producers are reluctant to share their personal stories of success and failure in selling grain.  But over the course of several years a number of these producers have let me in on their experiences using options. Their comments have led me to this question: If options are such a great pricing alternative, how come I meet so few producers who have had a positive (i.e. profitable) experience using them? 

My concerns over the use of options in pricing grain and livestock center on three issues: cost, complexity, and focus. 

Cost: I like to explain how options work using car insurance as an analogy. With car insurance, you pay a premium to cover yourself against “disaster” like an accident, at a cost that depends on how long you want to insure yourself and your “volatility” or risk profile.  Likewise with options premiums – once you strip away the intrinsic value (the strike price relative to the underlying futures market), the premium is determined by length of time to expiration and the volatility of futures price. 

Over the course of several years, does anyone expect to profit from the purchase of car or home insurance? I don’t think so.  Options, like insurance, occasionally pay out when disaster occurs.  But insurance companies take in more than they pay out.  Used regularly, options will cost, not pay. (Crop insurance is different because it is subsidized. The crop insurance industry generally pays out more in claims than it takes in – one good reason that I am a proponent of crop insurance.) 

Too many experts gloss over the cost issue.  I’ve heard and read many advisers who will say that for just 10 or 20 cents per bushel you can buy an option and establish a minimum price for your corn or soybeans.  “Just” 10-20 cents? In the world of commodities, 10 cents is a great deal of money.  If I could guarantee the average grain producer just 10 more cents per bushel, my advice would be worth thousands of dollars. So here’s my advice: quit spending the 10-20 cents on options.

Complexity: Options are incredibly flexible pricing tools. You can position yourself for virtually any price scenario.  However, this incredible array of market scenarios and pricing strategies overlooks one simple point – most of us have just a 50-50 chance of guessing which way the price will move tomorrow, let alone one week, one month or one year out.  The different combinations of option purchases and sales thus makes grain marketing more difficult and more complex, when most producers want to keep it simple.

Focus: Options strategies sound wonderful but they always carry a risk that is often not fully understood, and these strategies have an amazing way of starting out as a simple pricing effort but ending up as an active trading exercise.  Trading options can distract your attention away from more important things like executing your marketing plan, or trimming production costs from your operation. A traders’ approach is not necessarily the best approach for most farmers who aren’t comfortable trading.

I have no hard data on the percentage of producers who profit from options.  Anecdotal evidence suggests not many. Late last winter a producer told me of his visit to the local tax advisor. Perusing the producer’s records for the last year, the tax advisor ran across income he was puzzled about. “What’s the $1,000 profit in this account?” asked the accountant.  The producer explained that earlier in the year, he had bought some call options and made a modest profit.  The accountant – who prepares taxes for a large number of producers in the area - was surprised and said, “I’ve never seen that before.”

Options can be powerful pricing tools, but I caution producers to use them very selectively.  Too many producers have learned the hard way that using them often just detracts from their bottom line.

Online Sources to Learn More About Options

An introduction to grain options, Univ of Nebraska
 www.ianr.unl.edu/pubs/farmmgt/g770.htm

Hedging with a put option Texas Ag Extension Service
 http://mastermarketer.tamu.edu/factsheets/rm2-12.pdf

Use of Crop Futures and Options by the Nontrader, NDSU
 www.ext.nodak.edu/extpubs/agecon/market/ncr21718.htm

Marketing Puzzle: Futures Option Contracts, Okla State Univ
 http://agecon.okstate.edu/anderson/wheat/f-549.pdf

Examining Futures and Options Workbook: A 16-page workbook for classroom, seminar and marketing club use, which defines futures and options with examples, worksheets and self tests, using the Minneapolis Grain Exchange hard red spring wheat contract as an example.  Downloadable Adobe Acrobat PDF
 www.mgex.com/resources/materials.htm