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Clear rules for using futures options

AME Management: Define your objectives for commodities pricing

Many farmers say hedging is too expensive. However, there is an approach that can provide both relatively cheap price insurance plus an opportunity to enhance revenue. It’s also an approach that creates an opportunity to separate and take advantage of market movement both on commodities and on currency.

Options

Buying a futures option is insurance: it gives the buyer the right to buy futures (a Call), or the right to sell futures (a Put), at a particular strike price. Sellers (writers) of options are insurance underwriters; they take buyers’ price risk and charge a premium for doing so, with premiums determined by open auction.

A market example

On December 3, 2015, May soybean futures traded at $9.06. This was a strong rally from support two weeks earlier at $8.53½. The question was, should we price some of our stored beans for April/May delivery?

The rally looked like it could go at least as far as substantial overhead resistance at the 38.2 per cent retracement around $9.30. Guys at the coffee shop thought it could go a lot further.

On the other hand, other market watchers reminded us that Argentina’s new government was planning to reduce export taxes on beans and corn, giving its farmers incentive to increase production. Also, a huge crop was on the way in Brazil, and the Chinese were slowing their soybean purchases, so the great rally could reverse suddenly and return to the downtrend that paused two weeks earlier.

What to do? Pricing might miss much higher prices if the rally continued. But if we didn’t price, we could end up with a disaster.

The insurance aspect

Options are commonly used to place a floor under prices while taking advantage of a potential rally. In this example, the at-the-money May $9 Put had a premium of $.344/bu. This is relatively expensive: the premium is almost four per cent of the strike price. If futures were to go down to, say, $7.50, the intrinsic component of the premium would be $1.50, but the risk premium would decline by some or all of $.344. So, at the limit, we would net $8.656.

If price rose to $10.50, we would gain $1.44 on the actual soybeans, but could lose the $.344. The resulting $10.156 would be better than locking in the soybeans at $9.06, but for, say, two contracts it would mean a cash outlay of $3,440.

Would this be the best approach? Two rules give less cash requirement, more potential gain, but less protection. First, look at options near support. Second, premiums below three per cent of the strike price are inexpensive. In this case, the $8.60 Put was close to support and its $.186 premium was 2.2 per cent. With it, if price fell to $7.50, the buyer gains $1.10 on the intrinsic value, but loses $.186 on the risk component, for a net of $8.414.

On the other side, if price rose to $10.50, the net is $10.314 and, in either case, the cash outlay of $1,860.

Potential revenue enhancement

Many farmers find it difficult to sell on a rising market because they hope prices will keep rising. To make selling easier, buy an out-of-the-money Call near resistance when prices are moving up toward it. Also use the three per cent rule here.

In the soybean example, resistance is above $9.30. The $9.40 Call’s premium of $.216 is 2.3 per cent of the strike. With the Call, soybeans can be priced near resistance. If they break through and keep rising, the Call provides some of the additional price. If we price the soybeans at, say, $9.28 on a forward contract, and the price goes on up to $10.50, we have the $9.28 as well as another net $.884 because of the gain from the Call, for a net of $10.164.

Summary

This is all about risk management and being clear about your objectives. If your objective is simply to lock in a price on a rising market, then simply define a target and lock in when it’s available.

But if your objective is to protect against disaster and take advantage of favourable price movement, then a Put near support gives protection from a change in fundamentals that takes the market below support. They also give more reward on rising prices and require less cash outlay.

Buying a Call at resistance in a rally also helps give the discipline to sell at favourable prices. This year’s markets gave several opportunities to do either.

Seldom has there been a year like this one that illustrates the importance of exchange rate. Canadian cash prices have held relatively firm because a weak loonie has somewhat offset weak commodity prices. Developing separate trading strategies for the commodity and exchange rate can help manage the risk of both.

Larry Martin is a principal in Agri-Food Management Excellence agrifoodtraining.com.

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