More on options: Making the right call with calls

Results from a recent Farm Futures survey show farmers will plant roughly the same number of corn and bean acres — around 90.5 million acres. If true, this would be long term bearish for beans and long term relatively bullish for corn.

 

Estimating South America’s soybeans

At the start of the growing season the USDA predicted 159 million metric tons (mmt), or about 6.3 billion bean bushels, would be produced in South America (Brazil 102 mmt/Argentina 57 mmt). Considering the favorable weather conditions in Brazil, 105 mmt is possible. Argentina, on the other hand, has had excessive rain in parts and dry conditions in others, so yield estimates are wide ranging. In the last USDA report there were no production reductions, but the trade is skeptical. Currently ranges are 48 to 57 mmt. The under/over bet seems to be around 53 mmt.

If the average estimates (Brazil 105 mmt/Argentina 53 mmt) happen, the expected mmt will be missed by only 1 mmt or 40 million bushels. While a minor factor, Uruguay and Paraguay have also had good weather this year and may produce a combined 1 mmt that would offset Brazil/Argentina’s decreased production. If this happens, the bean market supply will likely be too high and could put downward pressure on beans.

However, if Argentina production is closer to 48 mmt it means there would be a 200 million bushel shortage that U.S. beans can fill with its burdensome 420 million carryout. If this happens, $11 per bushel futures is a real possibility.

On a side note, there are rumors that India may export 2 mmt of soymeal in the next quarter. While this doesn’t include any soy oil, it’s important to remember palm oil will be available in April from SE Asia, which looks great after last year’s dismal crop.

While short-term bean prices have been good, I’m concerned for prices long term. The basis market is dropping as the futures market increased, which is an indication that there is plenty of supply domestically. Usually fundamentals win in the long run.

 

New crop beans

While old crop bean values will be volatile until the South American harvest production is more certain, it hasn’t hurt new crop values. If the USDA confirms 90 million bean acres on March 31 report, and trend-line yields are produced (46-47 bushels per acre), it would mean a potential 400 to 600 million carryout. This potential is keeping pressure on new crop bean prices.

 

Corn

There is a lot of old crop corn left and demand is uncertain. If carryout increases, it will put pressure on new crop prices. I expect corn to trade sideways until the USDA report at the end of March.

 

Option strategies Part 3

Frequently farmers ask for my opinion on buying calls. While generally I’m not a big fan, purchasing calls can be a tool in a farmer’s toolbox. However, farmers must be careful to fully understand and consider both the advantages and disadvantages of using them. Regardless of my opinion on buying calls, I think it’s important that farmers understand all of their options when it comes to marketing their grain, so they can develop a plan that works best for them and provides the most piece of mind. Outlined below are several common call buying strategy options and the pros and cons for each scenario.

 

What is a “call” option?

Purchasing a call is the right to buy grain at a desired price. That price is called the strike price.

 

Why would farmers purchase calls?

Honestly, I have no idea why a grain producer would want to buy calls, because that means they want to buy more grain. In my opinion, farmers should always be grain SELLERS not buyers. Buying calls is speculating, plain and simple. Granted, it’s controlled speculation, but speculation is speculation. That said, for education purposes, let’s look at the reasons why farmers may consider it.

Farmers purchase calls in an attempt to capture upside potential, after selling grain at lower than desired prices. Put another way, purchasing calls allows for unlimited upside potential if the market rallies, but limits losses to just the premium paid if prices fall below a certain price point. Also, there is no risk of margin call when purchasing a0 call, as they require paying for this right up front.

This sounds great. A limited downside loss with unlimited upside potential sounds like a very safe and low-risk option.

Purchasing calls has several benefits, so often brokers will suggest this option to farmers by first showing risk assessments where corn could potentially hit $3 while also showing the possibility of getting $5 in the future. Such low prices can frighten farmers, while the hope of getting $5 is so appealing. Therefore, on paper this trade can seem perfect to farmers by minimizing fears and providing hope.

In many cases, brokers will first recommend selling cash corn or Hedge To Arrive (HTA) contracts as the market rallies above $4. And then they will recommend buying these “courage calls.” These calls can help farmers who have a hard time letting go because they are afraid of missing out on a huge market rally. The calls can help ease this fear. Since nobody can predict summer weather conditions, brokers often suggest leaving a farmers’ upside unlimited to take advantage of the unknown.

 

So, are you against purchasing calls?

I am extremely against purchasing corn calls. I always have more corn to sell, maybe not this year, but certainly next year and the year after that. While I always want corn prices to go up, it doesn’t always happen. However, corn usually has a market carry (i.e. future month prices are higher than current/near ones) and is the reason why I don’t want to buy calls.

(Note — The bean market carry isn’t as consistent as corn and inverses, i.e. future month prices are lower than current/near ones, happen more frequently. Therefore, my bean strategy is different than my corn strategy and one could make a better case for buying calls in the bean market.)

Why are you against purchasing calls?

Basically, if the market drops after purchasing a call, I’m out the premium paid. While farmers often purchase calls to have “courage to sell,” my farm operation doesn’t need courage to be profitable. It just needs profitable prices. With futures under $4 (typically not profitable), I need to be careful and think strategically. Following are several examples that illustrate my point.

 

Scenario No. 1

After selling cash corn today for $3.70, a farmer purchases a $3.80 July call for 23 cents when March futures prices are near $3.70 (July is $3.83).

Some brokers will call this a “reownership strategy with options.” Some end users call this a “minimum price contract.” All it means is a farmer has sold grain but believes the market has upside potential and wants to participate if it does. For most farmers, $3.70 is not a profitable sale. Adding the cost of the call (23 cents), to the $3.70 sale makes the trade now really $3.47, which is even worse.

As mentioned, corn has a carry (i.e. March is at $3.70 and July is at $3.83). If corn rallies from $3.70 to $3.83, then the farmer will get some money back (most farmers sell near expiration, in this case it would be June 23).

Interestingly, prices were similar to this scenario in 2016. Corn rallied to $4.39 in early June. So, this $3.80 call went from 23 cents to 63 cents in value (40-cent gain), while futures rallied nearly 60 cents. By the end of the week of June 18 weather was good, so the market fell 55 cents after five trading days, coinciding with when the July option expired at a 15-cent value.

 

Best case

Most farmers with these options held to the last day. It would have taken extreme “courage” to sell the week before the big drop (virtually no farmer did). But if they had, they could have pocketed a 40-cent gain. ($3.70 + 40 cents = $4.10). Not a horrible trade, but July futures hit $4.39, so the farmer missed nearly 30 cents more of opportunity —and this was the best case scenario for this trade.

 

Likely case

Most farmers would have held until expiration getting a 15-cent premium. After the 23-cent call purchase the farmer lost 7 cents, so they ended up with $3.63 ($3.70 – 7 cents). Most likely not a profitable price.

 

What would have your strategy been in this scenario?

In my opinion, 23 cents is expensive for $3.80 July futures. I would have doubted spring futures would drop below $3.47 (value of corn less cost of call) for a significant amount of time. I wouldn’t have sold the grain. I would have waited to see if the market went higher on weather scares and I would have sold futures when they were above $4, which is a profitable price and definitely at $4.20, I would have never held my old crop to $4.39. Granted there may have been some cost to roll my long position from March to May and then again to July, but it would have been less than 17 cents. At least $4.03 would have been likely and a reasonable outcome.

I say it all the time, I don’t try for home runs. I get base hits and keep moving forward. So many farmers prefer to swing for the fences. In the end, it depends on your risk tolerance.

 

Scenario No. 2

A farmer purchases a $4.20 Dec call today for 20 cents when futures prices are near $3.90 against the Dec. They then sells a $5 call today for 7 cents. This results in a net cost of 14 cents (including commission).

This trade strategy assumes prices will rally into spring and summer, allowing farmers to sell grain with futures or cash when breakeven points (or higher) are reached, say around $4.20. Then the farmer can participate in the rally all the way to $5 with almost no downside risk (besides the 14 cents). On paper this trade sounds reasonable.

In my opinion, this is a good speculation trade, because the risk is only 14 cents for a chance to make 80 cents. However, to be clear, this is NOT a hedging trade. There is a big difference between the two.

Still, this trade assumes farmers will know to sell at the top of the market, but often farmers continue to hold their corn as prices increase expecting prices to continue to go up. If a farmer did this trade last year and sold corn futures when it was $4.20 to $4.40, they would have likely been happy. However, after the 14-cent call cost, they only received $4.06 to $4.26. But, the market never rallied beyond these levels, and quickly went down after hitting the high. Most farmers did not sell at its peak. So in the end, this trade would have been a complete loss of 14 cents for most.

This trade is even worse for farmers who aren’t 100% sold at harvest (like I typically am). Unsold farmers always need the market to rally to get prices above breakeven points. So, if a call loses money, unsold farmers will be in an even worse position than they already were.

 

Ok, then I will just sell out of the call spread as prices rally?

Again it sounds like a good idea until you realize that by selling the $5 call to reduce the expense of the $4.20 call and you have significantly capped your profit potential.

 

Why did that happen?

In the scenario above, as corn rallies from $3.90 to $4.50, the value of the $4.20 call most likely increases in value from 20 cents to 64 cents. Also, the $5 call sold for 7 cents will also increase to about 22 cents. Now when the farmer sells the call spread they can only make 42 cents (64 cents – 22 cents) when the market moved 60 cents. Plus, this farmer needs to subtract the original 14-cent cost to get in the trade. This means the trade was a 28-cent net profit, which was half of the futures rally that was originally hoped for.

 

That doesn’t sound bad, why don’t you like that?

In the best case scenario for this trade, I risked 14 cents to make about 28 cents. That is not a great return for the risk I took. Plus, with this I’m assuming the farmer sold at the top of the market, which very few did, in most cases with this trade, farmers would have likely taken a complete loss after waiting too long to sell, well after the rally was over.

Again, I need to sell when I’m profitable and I can’t risk taking less hoping for some kind of home run. The chances are high that farmers will strike out with this play.

 

Would you be willing to do this on 5% to 10% of your production?

Maybe, but since it’s a speculation trade, I would be hesitant. Basically, this trade requires farmers to spend money hoping that the market rallies, which it usually will do from winter into summer. Why spend money on a trade that will likely happen anyway. I prefer that my marketing strategy assumes historical norms and trend lines, while still being prepared for rare events.

The bottom line: farmers need to sell at profitable price points. Speculating trades like this increases farmer’s risk somewhat needlessly.

 

Scenario No. 3

A farmer purchases a $5 Dec call today for around 6 cents when futures prices are near $3.90 against the Dec futures.

I consider this trade similar to playing the lottery. This trade isn’t linked to any sale, it’s just simply the right to buy corn if it hits $5. Why would a farmer with a $4 breakeven point want to have the option to buy grain at $5?

The “strategy” of this trade is, if futures rally from $3.90 to $4.50, the value of the $5 call will increase from 6 cents to 21 cents, a potential 15-cent profit. That doesn’t sound bad until you realize the market had to move 65 cents for this to happen, meaning the farmer received 25% of the market move, which sounds bad. Plus, this is the best case scenario from last year and it assumes that the farmer sold at the very top, which is unlikely.

I would almost never buy a corn call. They provide little downside protection and the market needs to rally substantially to make money on them. The thing is, I already need the market to rally to sell grain at profitable prices anyway, so adding this additional layer of speculation usually doesn’t make sense.

Farmers need to think about what their goals are when it comes to their grain marketing. Hardly any farmer (me included) has corn sold for the 2017 harvest yet. We already need the market to rally substantially in order to make a profit. Why risk more money on a speculation trade? A farmer already has a large amount of inherent risk in their operation. The key is not to add to this risk, but instead reduce it.

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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