More about options

Arguably, the report last week was the third most important report of the year (after planting intentions in late March and the actual planting and stock report in late June). It showed the final yield results for 2016.

 

Corn

There were few changes to the corn bottom line. Corn still shows a 2.3 billion bushel carryout, which is 30% bigger than last year. There will need to be a substantial reduction in acres (and most likely yields too) to support a substantial rally.

 

Beans

The report shows a small reduction in the U.S. crop production, which may be seen as bullish. However, there is still a 400 million bushel carryout. Also, the USDA increased the South American crop estimates more than the US crop reduction. This is despite some flooding in Argentina, because the Brazil harvest is supposed to be a record.

Regardless of this news, bean futures remain strong. This probably is because the market has seen that in the last five out of six years the USDA has had to reduce South American yields later in the year.

 

Wheat

The report indicated that wheat planted acres are expected to be at record lows, unseen in over 100 years. Around 30% of the reduction is expected to be in Kansas alone. Another 30% will be from Oklahoma and Texas combined. Nebraska, South Dakota and Montana will also see large reductions. Despite these reductions, a huge rally is still unexpected since next year’s domestic usage is already in storage. Also, since the U.S. exports 50% of its wheat, the dollar will be an important factor in wheat’s direction this year.

The obvious question is, what will these wheat acres be planted to? Based upon market conditions today, I suspect a lot of additional bean acres.

 

DDGs and Chinese tariffs

Last Wednesday there were reports of China imposing higher tariffs on DDGs. Some suspect this was the reason corn and beans traded lower the day prior to the report. I doubt this was a good reason for lower trade because DDG prices were extremely stable following the Chinese announcement, and many in that trade had already accounted for this issue. One trader even reported it will now make it easier to trade DDGs to China, now that a tariff level can be factored into prices. Regardless, even if the tariff could cause DDGs to be removed from feed rations in China, this would increase the demand for corn and bean meal as a replacement. Ultimately, Chinese tariffs on DDGs will not affect corn and bean prices much on a macro level in the longer term.

 

Option Strategy Part 2

Recently I’ve written several on common marketing strategies that I see brokers recommending to farmers that I may not recommend. I want farmers to understand all of the pros and cons of these strategies and why some may look good on paper, but in reality may not be the best for a farmer. Following is a common strategy brokers recommend before big USDA reports, like the one last week.

 

Option strategy

With March corn futures trading near $3.60 before the report, some brokers were advising farmers to purchase March $3.50 puts for around 5 cents. Basically, this trade allows farmers to guarantee a floor prices of $3.45 through the end of February.

 

Why would a farmer do this?

In theory, this would protect down side risk on unsold bushels in storage, while allowing for upside potential if a surprise drop in yield from the USDA report pushes futures higher. This protection has no margin call risk and only 5 cents cost upfront.

 

What are your concerns with this trade?

My biggest concern is the put provided a floor price of $3.45. Regardless of the direction of the market, the farmer doing this trade ends up behind. The following shows why.

 

What happens if the market drops after the report?

Farmers doing this trade need to ask themselves, how low do you expect the market to go? While I don’t know where futures will go, I doubt the market will trade much out of the range of the last few months, even with an unexpected increase in yield or production. Farmers have been extremely reluctant to sell corn when futures are below $3.45 in the last three months. So while $3.30 may happen, I doubt it will last long. Even if prices do go lower, this trade only protects farmers through Feb.

Let’s say the market does drop after the report, even then this trade is most profitable if the farmer can guess where the bottom is and sell the put back. Say the market drops to $3.30, and the farmer sells the put. Their profit will be 15 cents ($3.50 – $3.30 = 20 cents – 5 cents cost of put). While 15 cents profit may sound good, the farmer is now unprotected again and the market has to go up again considerably, when the farmer could have sold for $3.60 the day before the report. A farmer may have to settle for $3.45 or less if the market continues to trade lower. Basically, there is really no benefit for the farmer as they would have been better just selling for $3.60 the day before the report.

 

What happens if the market goes up after the report?

If the market rallies, the farmer will need to sell the put quickly to take any remaining value back out before it becomes worthless. This is hard to do, because usually once the market information is available the premium value in the put erodes quickly.

Best case scenario: the market rallies more than 5 cents from the $3.60 point and the farmer sells the put quickly and maybe only loses 2 cents. Otherwise they lost 5 cents and don’t have anything sold and still have the risk of a market drop down the road.

 

What happens if the market continues to go nowhere?

If the market continues to trade between $3.50-$3.65 the farmer will eventually lose all of the put value and be left with nothing but a 5 cent loss. Again, this trade doesn’t benefit a farmer in a sideways market.

 

So buying a put for 5 cents isn’t a good hedging idea?

I’m not saying that. Farmers just need to ask questions:

  • What is the goal of the trade?
  • Looking at historical trends, where will prices likely go? (Not where the farmer hopes they will go.)

If a farmer told me they were worried about prices going down after the report, I wouldn’t recommend that they put a floor on their grain 15 cents less than what it is currently trading at before the report. Plus, if the market did go up or sideways, the farmer will lose the put money. There are only three directions the market can go (up, down or sideways). So, if a trade only makes money if the market goes in one direction, then in my opinion it’s a risky and undesirable trade.

Also, in this trade should the market go a lot lower the best the farmer could get would be $3.45, rather than taking $3.60 before the report. To me this is a lose-lose-lose situation.

 

What if a farmer did this trade?

Now that the report is out, we know the market went sideways. Friday closed at $3.58, and puts are still worth about 4 cents. This means a farmer who did this trade is only out 1 cent (plus any commissions occurred, likely another 1 cent). While it may not seem terrible to be out 2 cents, with the market trading sideways, unsold farmers really can’t afford wasting 2 cents on trades that are mostly set up for them to lose.

Options can be effective tools in a farmers marketing strategy. However excessively trading them with no real purpose or strategy will likely leave the farmer frustrated. And in many cases, they are no better off.

Jon grew up raising corn and soybeans on a farm near Beatrice, NE. Upon graduation from The University of Nebraska in Lincoln, he became a grain merchandiser and has been trading corn, soybeans and other grains for the last 18 years, building relationships with end-users in the process. After successfully marketing his father’s grain and getting his MBA, 10 years ago he started helping farmer clients market their grain based upon his principals of farmer education, reducing risk, understanding storage potential and using basis strategy to maximize individual farm operation profits. A big believer in farmer education of futures trading, Jon writes a weekly commentary to farmers interested in learning more and growing their farm operations.

Trading of futures, options, swaps and other derivatives is risky and is not suitable for all persons. All of these investment products are leveraged, and you can lose more than your initial deposit. Each investment product is offered only to and from jurisdictions where solicitation and sale are lawful, and in accordance with applicable laws and regulations in such jurisdiction. The information provided here should not be relied upon as a substitute for independent research before making your investment decisions. Superior Feed Ingredients, LLC is merely providing this information for your general information and the information does not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision. The contents of this communication and any attachments are for informational purposes only and under no circumstances should they be construed as an offer to buy or sell, or a solicitation to buy or sell any future, option, swap or other derivative. The sources for the information and any opinions in this communication are believed to be reliable, but Superior Feed Ingredients, LLC does not warrant or guarantee the accuracy of such information or opinions. Superior Feed Ingredients, LLC and its principals and employees may take positions different from any positions described in this communication. Past results are not necessarily indicative of future results. He can be contacted at jon@superiorfeed.com.

 

 

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