How do you know weather isn't going to destroy your crop? You don't, so you buy crop insurance. By the same token, how do you know that grain prices won't destroy your farm profits? You don't, but most farmers don't take the proper steps to manage this risk. Today, we're talking about options and how they can work for you.
Continuing on with the insurance analogy, whether its life, health, or car insurance, the idea remains the same. The more protection you want, the higher premium you have to pay. We'll walk through the two most common options strategies for farmers, but first, let's go over some definitions:
- Call Option- gives the option buyer the choice to own the grain at a specific price on or before the expiration date.
- Put Option- gives the option buyer the choice to sell the grain at a specific price on or before the expiration date.
- Strike Price- the price the option can be exercised (executed) at.
- Premium- the cost to the buyer of purchasing the options contract.
Now that you're familiar with some terminology, we can set up some parameters. For the following example, we'll be looking into Farmer Dale, a corn farmer with 500 acres. He expects to achieve a yield of 190 bushels/acre, producing a total of 95,000 bushels at harvest. His break-even is $3.95 and his profit target is $4.85. This farmer has access to a futures and options trading account, as well as a marketing service.
Common Examples
Scenario #1: Put Floors - buy put option to protect downside risk.
Farmer Dale realizes midway through the production year that he'd like to have at least 25% of his crop protected from falling prices in the event markets get volatile. He can always sell futures to hedge if things get really bad, but for now, he wants to buy price insurance. By multiplying 95,000 by 0.25, Farmer Dale realizes he need to buy the equivalent of 23,750 bushels in put options. One contract buys the rights to 5,000 bushels, meaning that he should buy 5 put option contracts.
He decides he wants to protect that 25% of his crop at a price of $4.25. At the time, put options at a nearby strike price of $4.40 were offered at $0.12. To decide which strike price to use to protect $4.25, Farmer Dale used an option strike price ($4.40) and subtracted the option cost ($0.12) to get his effective hedge price of $4.28. If price drops below $4.28, Farmer Dale has hedged 25% of his crop, and loses no money on that portion of his crop.
Scenario #1: Put Floors - buy put option to protect downside risk.
Farmer Dale realizes midway through the production year that he'd like to have at least 25% of his crop protected from falling prices in the event markets get volatile. He can always sell futures to hedge if things get really bad, but for now, he wants to buy price insurance. By multiplying 95,000 by 0.25, Farmer Dale realizes he need to buy the equivalent of 23,750 bushels in put options. One contract buys the rights to 5,000 bushels, meaning that he should buy 5 put option contracts.
He decides he wants to protect that 25% of his crop at a price of $4.25. At the time, put options at a nearby strike price of $4.40 were offered at $0.12. To decide which strike price to use to protect $4.25, Farmer Dale used an option strike price ($4.40) and subtracted the option cost ($0.12) to get his effective hedge price of $4.28. If price drops below $4.28, Farmer Dale has hedged 25% of his crop, and loses no money on that portion of his crop.
Scenario #2: Call Options for Re-ownership - buy call option to extend upside profits.
Prices have been flying higher in November after Farmer Dale already has 90% of his crop sold. After getting word from his grain marketer that prices are predicted to go much higher, he decides he wants to re-own %15 of those bushels he sold earlier in the year. That means, he must buy three calls because 15,000 is the closest 5,000 divisible number to his equivalent of 12,825 (15% * (95,000*90%)) bushels in options.
Farmer Dale could lock in profits now with futures at $5.53, but his best case scenario goal is at $5.75. Using his goal price of $5.75, he uses a nearby strike price of $5.80 to buy three call options at a offer price of $0.09, producing an effective price of $5.89. By doing so, he has purchased the right to buy 15,000 bushels at $5.80, which he would turn around to sell for much more depending on how much time and price movement there's been in the meantime. For the sake of example, let us say Farmer Dale sold his call options for $0.21 each, yielding a net profit of $1,800.
Prices have been flying higher in November after Farmer Dale already has 90% of his crop sold. After getting word from his grain marketer that prices are predicted to go much higher, he decides he wants to re-own %15 of those bushels he sold earlier in the year. That means, he must buy three calls because 15,000 is the closest 5,000 divisible number to his equivalent of 12,825 (15% * (95,000*90%)) bushels in options.
Farmer Dale could lock in profits now with futures at $5.53, but his best case scenario goal is at $5.75. Using his goal price of $5.75, he uses a nearby strike price of $5.80 to buy three call options at a offer price of $0.09, producing an effective price of $5.89. By doing so, he has purchased the right to buy 15,000 bushels at $5.80, which he would turn around to sell for much more depending on how much time and price movement there's been in the meantime. For the sake of example, let us say Farmer Dale sold his call options for $0.21 each, yielding a net profit of $1,800.
Hedging/Risk Summary
The purpose of hedging is to offset the risk of losing money on your cash crop. When people see a $3000 loss because of hedging, they must remember the insurance analogy. That cost may, one day, save them countless times more. Freak accidents, car crashes, and plummeting prices can all be financially covered with insurance, which comes at a cost. When it comes down to it, the question isn't whether you can afford it, but whether you can afford NOT to have it.
The purpose of hedging is to offset the risk of losing money on your cash crop. When people see a $3000 loss because of hedging, they must remember the insurance analogy. That cost may, one day, save them countless times more. Freak accidents, car crashes, and plummeting prices can all be financially covered with insurance, which comes at a cost. When it comes down to it, the question isn't whether you can afford it, but whether you can afford NOT to have it.