Taming the Bulls & Bears

Using Put Options 101: Consider a Put as Nothing More Than Price Insurance

By Betsy Jensen,
Ag Commodity Instructor, Northland Community and Technical College

More farmers are beginning to understand how put options work, but it is also important to learn how to use a put option.  It is a marketing tool that will work better under certain market conditions, and we’re going to discuss how to recognize those conditions.

Before we go too far, I want to make sure everyone understands how puts work. A put is the right, but not the obligation to sell grain at a specified price. Let’s say that in May you work with a marketing advisor to establish a $3.50 Sept Mlps wheat put.  This gives you the right to sell grain in September at $3.50. In September, if the futures market is trading at $3.00, your put option will be exercised, and you can sell wheat at $3.50. On the other hand, if the futures market rallies to $4, your put option will expire worthless, and you can sell your grain at $4. Remember that a put is the right to sell, but you are not obligated to sell at that price.

In order to have the right to sell wheat at $3.50, you pay a premium.  Premiums are determined by the market and you can pay anywhere from $1.00/bu to $.01/bu. A $4 put will be more expensive than a $3.50 put, because you would much rather sell wheat at $4 than $3.50. Time is also a factor in determining premium value. December puts will be more expensive than September puts because there is more time, more risk and more uncertainty. 

Puts are nothing more than price insurance.  When you buy a put, you are setting a price floor. If you buy a $3.50 put for $.20, it means that $3.30 is your price floor ($3.50 minus your $.20 premium). You will not receive a futures price lower than $3.30, but yet your upside potential is unlimited. If the futures market rallies to $5.00, you can sell your wheat for $5.00, minus the $.20 you paid for your put option. 

So how can you use put options in your marketing plan for 2001?  Well the bad news is you probably cannot lock in a profit this year.  On the average, we say the cost of production is approximately $3.50/bu, and you just can’t buy put options that lock in a $3.50 cash price.  If wheat rallies sharply, you might have the opportunity, but based on current market conditions, put options will only help to minimize losses, instead of guaranteeing a profit.

Take Advantage of the Carry
So why even bother talking about put options now?  Because of the carrying charge (Remember the carrying charge is when distant months are higher than the nearby months, i.e., Dec higher than July).  The carrying charge gives you an opportunity to lock in a higher price for a distant month, and put options can help you take advantage of those prices.  Farmers should always look for ways to “sell the carry,” and put options help you do that. 

I mentioned before that Dec options would be more expensive than Sept because there is more time, more risk and more uncertainty.  That is not true under the current market conditions.  Because we have a full carrying charge in the market (a full carrying charge means prices are at least 3 cents/month higher), put options become cheaper the further out you go.  In the wheat market, Dec options are actually cheaper than Sept! This makes put options very attractive, and very reasonably priced. Just pick one strike price such as $3.50, and look at the put option premiums for every month. The farther out you go, the cheaper they become. Compare wheat puts to soybean puts, where there is no carrying charge. Soybean puts are much more expensive. 

Puts are an excellent tool to use in your marketing plan, especially with the full carrying charge in the wheat market.  They provide a price floor, but your upside potential is unlimited if we do get a big rally this fall. You buy crop insurance with the hope that you will not have to use it, and the same applies to put options. You hope wheat rallies this summer and you don’t have to use your put options, but they are your back up plan.  In 2000, if you would have bought puts in the spring and held them until fall, the puts would have made you money.  We don’t know whether prices are going up or down, and puts help minimize your exposure to price risk. 

If you purchased Crop Revenue Coverage, Revenue Assurance or Income Protection insurance this year, you have already purchased puts on your crops, so to speak.  Those crop insurance policies will provide coverage if prices go down.  Most farmers probably purchased the 70% coverage, but you can still buy puts on your last 30% since that is unprotected from any downward price movement.

“Taming the Bulls and Bears” is a market education feature of Prairie Grains, made possible by the Minnesota wheat checkoff managed by the Minnesota Wheat Research and Promotion Council. If you have a question or topic related to marketing that you’d like to see addressed in this feature, send it to: Minnesota Wheat Council, Attn: Prairie Grains Editor, 2600 Wheat Drive, Red Lake Falls, MN, 56750; Phone: 1-800-242-6118 or email Jensen: bjensen@nctc.mnscu.edu