Use Put Options for 2008 Wheat Sales?

The following commentary was written by Melvin Brees, Missouri Extension economist, in his August 17 ‘Decisive Marketing’ newsletter, which he does monthly. Go online to www.fapri.missouri.edu/farmers_corner for crop budgets, software tools, and Brees’ monthly newsletter, generally released the third Friday of the month.

Old crop (2007) wheat futures prices have rallied to the $7.00 range recently on worries of tight world wheat supplies. While not as high as the old crop futures prices, new crop July 2008 wheat futures prices have also increased. Both the Chicago Board of Trade (CBOT) soft red winter (SRW) wheat futures prices and the Kansas City Board of Trade (KCBT) hard red winter (HRW) wheat futures prices have moved into the upper $5.00 price range. These prices are offering opportunities to sell 2008 production at prices seldom offered at harvest time.

These July 2008 futures prices are also offering the opportunity to use a put option to set a futures price floor near $5.00. Thursday, August 16, 2007, CBOT closing price was $5.75 ½ for the July 2008 wheat contract. A $5.70 strike price July put option with a premium (cost) of $0.52 protects a net futures price of more than $5.15. That’s the $5.70 strike price minus $0.52 premium, minus brokers’ fees. A $5.30 July premium of just over $0.30 protects a net futures price near $5.00. KCBT options offer similar prices for producers in western Missouri where SRW wheat is priced off of HRW wheat futures.

Although these options require a significant cash outlay in order to cover the premiums, they provide the opportunity for low risk price protection. There is no delivery obligation, no futures market margins to cover if prices move higher and, if prices do move higher, the wheat could still be sold at higher prices. Other than the risk of losing the option premium, this appears to be a low risk opportunity to protect a favorable futures price for 2008 wheat production.

Using Put Options for Downside Price Protection
An option to sell a futures contract is a put option. The buyer of a put option purchases the right to sell futures. The writer (seller) of the put option must buy futures (take the opposite side of the futures transaction) if the buyer exercises the option. For the right to exercise the option, the buyer pays the seller a premium.  The buyer of a put option will make money if the futures price falls below the strike price. If the decline is more than the cost of the premium and transaction, the buyer has a net gain. The seller of a call option loses money if the futures price falls below the strike price. If the decline is more than the income from the premium less the cost of the transaction, the seller has a net loss.

When using a put option, your grain is still sold in your traditional local cash market. You buy put options, which are converted to money (if they have value) when the grain is sold on the cash market. The options are allowed to expire if they have no value. Options represent a potential position in the futures market, so they must be in increments of 1,000 or 5,000 bushels. Your realized price for your grain is a combination of the cash market and options market transactions.

Options allow the producer to establish a minimum price without giving up all of the gain if cash prices rise. Your ability to predict basis determines whether your minimum expected price is achieved. The amount paid for price protection using a put option is known at the time of purchase (the option’s premium). Unlike hedging with a futures contract, there is no margin account to maintain. The advantages versus disadvantages of using put options to market your grain are shown below.

Put Option Advantages

1. Extends time period to make a pricing decision
2. Risk of an adverse change in price is eliminated
3. Producer obtains some of the gain from rising prices
4. Eliminates margin requirements
5. Generally a very liquid market allowing the producer to quickly reverse positions

Put Option Disadvantages

1. Risk of an adverse change in basis
2. Cost of options (premium) may be greater than the value of the price protection
3. Options sold only in 1,000 and 5,000 bushel increments
4. Requires understanding of options, futures markets, and basis
5. Choices are substantial and can be confusing

Sources: Using Commodity Futures and Options for Grain Marketing, Larry D. Makus and Paul E. Patterson, University of Idaho, http://info.ag.uidaho.edu/pdf/CIS/CIS1089.pdf

Grain Price Options Basics, Don Hofstrand, Iowa State, www.extension.iastate.edu/agdm/crops/html/a2-66.html

For more information on put options and other marketing strategies: Go to the National Ag Risk Library, www.agrisk.umn.edu – click on ‘ag risk library’ then ‘price’