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Options in a bear grain market

If you’ve been leery of high-quality put options, Errol Anderson wants to change your mind

We’ve all seen it. Grain markets can take on narratives that uncouple them from the basics of supply and demand.

A bull market can charge forward, horns thrust in the air, and it can generate a level of excitement and pricing that sellers love, but privately marvel at. It’s heady, it’s optimistic, it’s confident, and it’s often irrationally exuberant.

To sellers like farmers, a bear market isn’t nearly as much fun. It can go crashing downwards, seemingly ignoring all the underlying demand as it roars, swipes and mauls its way through the numbers, feeding on fear, panic and eventually capitulation.

We’ve just been through a historic bull market in grains, one that’s likely to be talked about for years. And now we appear to be entering a bear market. Some analysts are resisting the notion, expecting a quick bounce-back in prices. Others are quietly suggesting it looks like some pain is just down the road. Still others are fearful that this could be a grinding bottom that goes on a while.

As part of our ongoing marketing series, Country Guide spoke recently with Calgary-based market adviser Errol Anderson, who took us through some of the ins and outs of understanding bull and bear markets, how they work, and strategies for finding success in both.

Country Guide: Everyone understands a bull market is one that’s generally trending up, and a bear is one that’s either falling or bouncing along the bottom. What else do we need to really get our heads around?

Errol Anderson: One of the most important things to understand is how their lengths and shapes tend to vary. Bull markets simply aren’t as long as bear markets. On average, markets are in bull territory about a third of the time, and bear territory about two-thirds of the time. Markets that are bullish typically have a spike top, so if you’re looking at a chart, prices can streak upwards to a frenzied peak in the final stages of a bull market, then they can go almost straight down. The example everyone is looking at right now is oil, which climbed up to about $100 in early summer and then sank below $50 over a matter of a few months. Then, when a bear hits bottom, it develops a long U-shaped trough, and it doesn’t tend to quickly spike back up.

Farmers can get caught up in both equally. When it’s a bull, a natural tendency is to wait for even higher prices, but many wait too long. Prices peak, but then the ride down is very quick. And when prices are depressed and at times below the cost of production, I think there’s a tendency to expect them to recover back to past levels, and unfortunately, because of what we know about the length of bear markets, that doesn’t usually happen. So sometimes farmers tend to miss opportunities to price crop well above average prices, hoping for better later.

I think analysts like us and other market advisers are frequently seen as pessimists because of this, but really what we are is risk managers. It’s because bull markets just simply have a much shorter shelf life. And that reality must be respected by any producer of raw commodities. If a farmer is trading in commodities, it should be for business risk management purposes. Certainly there are speculators in the market, but farmers should be cautious not to increase their speculative risk within their business. They’re already speculating heavily on agricultural commodity prices every time they plant a crop. They and their advisers should be looking for opportunities to price crops profitably, and those opportunities will appear, in any market.

If you can understand how these markets are structured, how they differ in their behaviour and psychology, you can begin to plan your marketing strategy.

CG: Tell us more about that — what would these strategies look like?

EA: At their heart, they’re going to revolve around using market tools to manage risk. In a bull market, you want to avoid missing the opportunity to price your crop well above the average because you’re waiting too long looking for the market peak. In a bear market, you want to likewise capture good opportunities, but market recoveries in a bear market lack the firepower of a bull market.

Whether it’s a bull or a bear market, leaving your emotions and ego out of a decision is a key price management strength.

In a bear market, for example, you might hope prices will go higher, but you can’t know that. You may, however, have a profitable pricing opportunity right in front of you that you don’t want to miss. So one strategy that you might consider is to pull the trigger and sell the grain, thus locking in that profit. Then you can turn around and purchase a call option which can reopen your price ceiling after the cash grain is sold. A call gives you the right, but not the obligation, to purchase a futures contract at a predetermined strike price for a later date. By selling cash grain, you inject cash flow, while call option ownership offers you the ability to participate in market upside if it happens later.

In a bull market, you can also guard market downside risk if you decide to continue to store your unpriced grain in an effort to speculate on even higher cash prices. The tool I like in this circumstance is a put option, which is the right, not the obligation, to sell at a predetermined time and strike price. A strategy I’m supportive of is a “scaled-in” put buying program. Farmers may scale in puts as the futures climb, and as those prices climb, the put premiums will decline in value, until that market begins to fall. As the futures decline, these put premiums spring back to life and essentially act as price insurance. A key advantage of this tool is that there is no risk of margin calls. But if the market simply doesn’t break, these put premiums can expire worthless.

To be honest, we’ve lost clients over expired put premiums, but in this case, cash grain prices held up and the grain was sold very profitably. The cost of the puts is simply a cost of risk management — like an insurance premium.

CG: Is the best available option a commodity account then? Aren’t there other options?

EA: There are many cash grain contracting alternatives that can mimic the power of a commodity trading account. There are tools like deferred futures contracts from local grain buyers that can tie in call options, for example. But the decision may be one of simplicity or flexibility. Cash contracts offer simplicity since the farmer won’t have to open a commodity trading account. But a cash contract is also rigid and binding, tied to the delivery of the grain

Nothing can beat a commodity account for flexibility, in my opinion. There is no commitment for grain delivery and options contracts can be easily entered and exited through the life of grain ownership and beyond. So there is a place for both cash contracts from grain buyers and a commodity trading account in a farm pricing program. It really comes down to the individual grower, their appetite for market involvement and the need for pricing flexibility. Someone who doesn’t really enjoy following the markets and keeping informed may be more drawn to these cash tools. But for a more sophisticated marketer, who actually enjoys following the markets and understanding them, I think they would be well served by using a commodity account and that array of tools.

CG: The two most common tools are futures contracts and options contracts — calls and puts. Can you run us through how they differ and where they fit?

EA: A futures contract is exactly what it sounds like. You’re buying or selling a standardized lot for a price agreed upon today for future payment and delivery. So a July canola contract, for example, will be priced and bought or sold today, for the right to deliver or take delivery six months from now.

They’re popular with people who have a fairly high risk tolerance, and in my experience, they take good nerves and a lot of discipline. Futures contracts are very volatile. Using the futures market outright, for a beginner, can be much like climbing into a Formula 1 race car and not truly understanding just how much power is actually under your feet.

Typically they’re bought on margin, with a market participant being responsible for maintaining a minimum margin requirement. If you’re trading futures, you will be exposed to potential margin calls. So let’s say you purchased a canola futures contract to reopen your price ceiling after you sold the physical cash canola, but futures drop. You may get a margin call to top up your trading account. The broker will request funds be wired or bank transferred immediately. If this situation would make you lose sleep at night, then you’re a candidate to trade options or simply use cash contracts. Margin calls are inevitable if you trade the futures outright, so it’s a risk tolerance question. That’s where the nerves and discipline come in.

An option is also exactly what it sounds like. You’ve only got the option, not the obligation. You’re basically buying or selling the option to buy or sell at a certain strike price. Some farmers will own both put and call options, but for different reasons. They may own puts to guard the downside on unpriced grain, and own call options for grain that has already been priced. That’s where the flexibility comes in and it can be quite rewarding in a farm marketing plan.

For example, you think there’s a risk the market could fall, and you scale in put options throughout the run-up in the market. Once the market peaks and begins its descent, put options regain their value and do their job of price protection. Or if you want to take advantage of a possible spring price rally, you “cold scale” in call options through the winter on market dips. Remember that as a market falls, call option premiums drop in value. A farmer can scale in put options in a rising market or call options in a falling market — there’s lots of market flexibility here.

A key advantage of trading options over futures is there is no margin call risk. Some people still find it nerveracking when the futures move in the opposite direction from their market position. But for options, there is no margin call trigger. You know right up front how much exposure you have in the market, which is the cost of the premium. So staying disciplined with options in a marketing plan can be easier, depending on your personal risk tolerance.

CG: Why don’t more farmers use options more routinely?

EA: I think it’s true, options sometimes get a bad rap at the coffee shop. I think a lot of people don’t really understand them, or understand how to use them. I think a lot of people who are interested in trading futures outright are attracted to the razzle-dazzle and volatility of the market. But when trading options is a risk management tool, there isn’t as much razzle-dazzle — but also not the potential for stress. And often options premiums can expire worthless. This can actually be great news, but it may not seem like it to the coffee shop.

To me, when buying options, it’s an issue of quality. You can get good returns from options, but you’ve got to be prepared to spend the money to purchase quality contracts, which not everyone is willing to do. Let me give you an example. Today we were buying May canola $450 put options and we were paying about $18 a tonne for them. We could also get a May $420 canola put for $9 a tonne.

Now if you get a moderate pull down in the market, those higher-quality $450 puts are going to begin paying almost immediately, because the strike price is close to the actual futures price. The $420 put premiums will increase in value, but at a much slower pace. But people really hesitate to spend that kind of money for what’s really floor price insurance.

This really is something farmers should discuss with their market advisers.

CG: So how should farmers decide on futures or options?

EA: I always tell my clients: “It depends on how well you sleep at night.” It’s all about their risk tolerance. If their trading account can keep them awake at night, I don’t think futures are for them. One of the things I’m sure you’ve heard me say is that we spend a lot of time with new clients trying to gauge exactly this — what’s their risk tolerance.

Everyone needs to decide where they fit. There are people who only want to do futures. They know margin calls are inevitable and they’re prepared for them. Others want some combination of futures and options. Still others want the simplicity and well-defined risk of straight options. Another group would be best served by using cash contracts that mimic features of the futures market through their local elevator.

Only by honestly assessing your tolerance for risk and your own personality will you know what’s right for you. If you’re new to using these tools, you have to take the time to understand them and your appetite to use them. But if you’re prepared to do that work, there are a lot of tools and an incredible amount of flexibility available to you.

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