Grain Options Can Boost Marketing Flexibility

By Robert Wisner

There are several ways options markets can be used in marketing grain (and livestock), as well as in feed purchases. The simplest and most direct use is for buying price insurance, in effect insuring that your selling price will not be below some specific level.

The easiest way to obtain price insurance for your crop with the options market is by buying put options from a commodity broker. It is important to note that there are two separate options markets for each commodity:
(1) puts and
(2) calls.
For trading to take place in either market, a buyer of the option and a writer or seller of the option are required.

Buying a put, gives you the right but not the obligation to sell your product on the underlying futures contract at a specific price. Buying a call option gives you the right but not the obligation to buy a product on the underlying futures contract at a specific price. The underlying futures contract is the one with the same delivery month as the option.

The call market is used commonly for price protection by processors, exporters and livestock feeding operations that want to insure a maximum purchasing price for grain or soybean meal.

In buying puts to insure a minimum selling price, the initial outlay for the premium and the brokerage fee are your total financial exposure in options markets. Unlike futures trading, if you buy options you will not be asked to deposit additional money with the broker, no matter how high or how low prices go. If prices are low at harvest time and you had purchased put options earlier at a strike price above the current futures price, you would be in a position to collect on your insurance policy. You could do that by selling your grain in the local cash market and also selling your option at an increased premium value to close out your market position. If prices are sharply above your initial strike price, your put option would probably be worthless so you’d let it expire and take the higher cash price.

When to Use Options
Note that from an after-the-fact analysis, options markets will almost always come out as your second-best marketing alternative. With declining prices in the above example, you would have avoided the premium cost by contracting at a local elevator or hedging directly in futures contract. And with rising prices, you would have been better off by staying completely un-priced and avoiding premium costs.

But marketing decisions cannot be made from hindsight and always involve uncertainty. If you can’t risk lower prices but feel there is some reasonable chance the market will strengthen, it may make sense to use the options market. And you can use options in combination with hedging or contracting. You can use options to insure a minimum selling price and protect your financial position, and then contract or hedge at a higher price if the market rallies sharply. Or you can hedge or contract to protect against lower prices, and buy call options to benefit from a possible rising market.

Sometimes a hedge or forward contract plus call option purchases will provide the same degree of price protection and marketing flexibility as put options, but at substantially lower premium costs.

Options also provide added flexibility in case of crop problems. In our earlier example, suppose you had priced 10,000 bushels of beans in the options markets and were hit by severe drought that cut your crop yields 50% below normal, and that market prices rose sharply. In that situation, you could let your option contracts expire with no problem, except that you would be out the initial premium. Your market position could be much more complicated with an elevator contract calling for delivery of 10,000 bushels, when you only produced 5,000 bushels and had to buy out the other half of the contract at $6.50 or $7.00 per bushel.

Substitute for Storage
To sell grain at harvest but retain the opportunity to benefit from strongly rising prices, producers can offset harvest sales by buying call options. If futures prices rise significantly above-the initial strike price, the options contracts should increase in value. If prices decline, the producer would lose only his/her initial premium payment plus a small brokerage charge. If you use this alternative, however, keep in mind that distant futures prices at harvest usually reflect a seasonal increase in cash prices due to seasonal price patterns and post-harvest strengthening of the basis (differential between cash and futures prices).

When selling grain at harvest and buying call options, you give up these sources of post-harvest improvement in grain prices, but retain the opportunity to gain from unusual developments that could bring a greater than normal seasonal rise in cash prices.

Wisner is an Iowa State University extension economist.  You’ll find a wealth of marketing information and links on his web site, www.econ.iastate.edu/faculty/wisner/.

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Online Sources on 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