Using futures and options in uncertain times

Already, 2017 has been a year of uncertainty due both to unpredictable weather and political patterns. (We won’t speculate on which is the less predictable!) Uncertainty breeds large amounts of price volatility.

Many farmers argue that using futures and options is too hard and carries the risk of cash-flow drains. They prefer to use the cash market and forward contracts.

Indeed, we know a number of farmers who develop a series of targets and pull the trigger on either forward contracts or cash sales when/if the market hits the targets.

This is a good strategy, but it has four limitations:

What happens if your targets aren’t met? You have considerable price risk on any unpriced portion of the crop.
What happens if the market explodes to unexpected levels after your target has been met? Your neighbour, with whom you’re competing for land, may reap a considerable premium by not pricing earlier.
What happens if (as often happens) the basis is lousy when futures are rising? Why take a forward contract or cash sale with a very poor basis?
What happens if you have a partial crop failure? We’ve seen people who thought they were 50 per cent (or less) contracted, but were actually more than 100 per cent contracted because the crop wasn’t there.

To deal with these eventualities, we have developed a few rules for pricing discipline. They seem very simple when not dealing with the reality of daily and erratic price movements.

Price just under major resistance or support planes, with forward contracts or by selling futures.

If using futures, place buy stops on two consecutively higher closes than resistance.
Buy out-of-the-money put options near support with premiums at three per cent or less of the strike price for a reasonable cost to set a floor price.
Buy out-of-the-money call options with premiums three per cent or less of the strike price for a reasonable cost to protect against pricing too low.

The December spring (Minneapolis) wheat and November canola charts on July 24, 2017 (see below), illustrate the application of these rules. From September of 2016 through early June 2017 the December spring wheat contract traded in a range defined by the key reversal top at $5.88 on December 2, 2016, and the key reversal bottom of $5.44 on April 10, 2017. Using the rules above, we would have recommended:

Selling futures or forward pricing 2017 spring wheat above $5.80. This would have got us priced in December, early March, early May or early June. (With futures we would likely have taken profits in late April and sold again.)
Buying $5.40 September or December puts for a floor or $5.90 September or December calls to protect against a weather problem when the premium was under three per cent (about $0.17). Buying calls would be done in conjunction with a forward contract, not with selling futures.

2017 charts for wheat and canola have already proven that it’s wise to have a plan in place to take advantage of market volatility. In fact, without this volatility, markets can seem downright dismal.

As we now know, there has been a weather problem that took spring wheat to almost $8.50. At midday on July 24 with futures at $7.63¾, the value of the $5.90 call was at least $1.73¾. Assuming it cost $0.17, selling the option would add at least $1.56 to the original contract price.

If pricing was done by selling futures, the stop loss rule would have kicked in on June 5 at around $5.91, providing a small loss, but giving the opportunity to sell again much higher either near the $8.50 top or the $7.40 low.

The floor price remains in place at $5.40, though it would likely be wise to raise the floor by selling the $5.40 and buying one closer to the money.

Canola is a different story. It traded between a double bottom at $472 on August 2, 2016, and a double top at $520 in June 2016, having given several chances to price above $510, and a couple of opportunities to take profit below $480. The exception to date was July 10 and July 11, 2017, when the market jumped above the $520 resistance plane.

Applying the rules would result in one of the following:

Forward contracts near the $520 tops.
Using the two-close rule on futures, a short futures position above $510 would still be in place on July 24 when futures closed below $495 because the second close above $520 didn’t exceed the first one the day before.
A solid floor at $472.

Final thought

Every year has its unique events. Unexpected factors such as weather issues can disrupt markets, but also give grain producers short-term pricing opportunities. If they don’t occur, pricing opportunities may be dismal, which would likely have been the case this year absent the drought.

Doing nothing and waiting to sell at or after harvest could be disastrous if weather patterns normalize and another huge crop materializes as expected in Brazil and Argentina. Developing a disciplined strategy for how to deal with uncertainties can be the difference between profit and loss.

Larry Martin is a principal in Agri-Food Management Excellence, which runs the Canadian Total Excellence in Agricultural Management (CTEAM) program. www.agrifoodtraining.com