Breaking the marketing boom or bust cycle

Do you wish you could have a 'do over' when a marketing strategy fails? Using put and call options is the closest thing to it.

“Do overs.” This is what farmers need when they market – the chance to reverse a decision made earlier in the season. It was certainly needed this year for those who decided not to price 2014 production early. That turned out to be a huge mistake.

Farmers sometimes end a season feeling pretty good about the marketing decisions they made. Unfortunately, seasons like that tend to be the exception. All too often, farmers end the marketing season wondering, “What was I thinking?”

Most farmers often take an “all or nothing” approach to selling crops. They will spend the marketing season trying to decide if they think prices are going up or going down and then base their decisions on that opinion. If they guess right, they are happy with the results, if they guess wrong, not so much.

Look for strategies that fall somewhere between selling and not selling. You can have a market opinion, it is almost impossible not to, but it is a good idea to protect yourself in case you are wrong.

There are two ways of doing that, and both involve using marketing tools that have been around almost 30 years – put and call options. Most producers have some experience buying options, but more times than not, their experience was not good, with the major complaint that they lost money when they bought calls or puts. That tells me their objective was to generate income, and I am not surprised they were disappointed. As a speculative investment, buying options is often not a good strategy.

By their very nature, options tend to be priced to the advantage of the seller and will often expire worthless. But, when it comes to managing price risk, puts and calls are the farmer’s most versatile tools.

Since you do not know if the market is going up, down or sideways, a producer needs protection should prices go down but can still benefit should prices go up. There are two ways of achieving this with options. You can price production and buy calls, or you can buy puts to protect production you have not priced.

Let’s go back to early last summer. November soybean futures spent most of April though June trading in the $12 to $12.50 range. It is understandable those prices were not that attractive to producers who remembered the great harvest prices they got the previous season. Most regrettably chose not to sell or at least not sell much, hoping for better prices later in the season.

The alternative we suggested at the time was to price a decent percentage of expected production and back up at least a portion of those sales with out-of-the-money calls.

Calls generally increase in value if the market trades higher and can become worthless if the market goes down. To figure your futures price floor simply take your booking price and subtract the cost of the calls. For example, if a producer booked soybeans when November futures traded to $12.50 last May and spent 25 cents for November calls ($13.60 strike, 5/20/14), the futures floor would have been $12.25 not counting basis. As it turned out, the market went down and the calls were worthless when the crop was harvested but the $12.25 price floor looked pretty good. Had prices gone the other way, the calls were there to provide upside potential.

What about the balance of the expected production? Farmers know what can happen if you overbook and prices go up. An alternative last spring was to protect the expected balance with puts. Puts generally gain value if the market falls and can become worthless if the market goes up. On May 21, when November soybean futures traded to $12.50, November $12 puts traded between 41 and 49 cents. Had a producer bought the $12 puts and spent 45 cents, his or her price floor discounting basis would have been $11.55 ($12 – 45 cents, strike price less premium). Once again, the price floor provided by this strategy looked good by the time harvest rolled around. Had prices gone the other way, the puts would have lost value, but the producer would have been able to price the balance of the crop into the higher cash market.

There are a couple of concepts to keep in mind when you consider buying puts to protect unpriced production. One, you hope the puts expires worthless. Puts gain value if the underlying futures market falls. That is fine for the puts, but not so good for the unpriced production the puts were bought to protect. A much better outcome would be for the futures market to go up, the puts expire worthless and the actual production sold at a higher price level.

Two, you are generally not able to establish a price floor close to the current market price unless you are willing to spend a great deal of money. The higher the level of price protection you get with a put, the more you have to pay. Finding the appropriate balance between the cost and level of protection often takes you to a less expensive lower strike price.

There is another characteristic of the put strategy that offers a producer an important benefit. If prices go up, and you do not make the production protected by the put, no one is looking for a delivery. Downside protection, upside potential and no production risk. This is a powerful risk management tool every producer should do their best to have in their marketing toolbox.

Using options to help manage risk is not as much fun as trying to outguess the market. But as farmers found out again last fall, selling at a low price when you could have done much better is no fun at all. Take another look at options, but this time, learn how to use them properly. It’s the closest thing to a “do over” you are likely to find.

 

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