Frequently farmers ask for my opinion on buying puts. While generally I’m not a big fan, purchasing puts can be a useful 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 puts, 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 put buying strategy options and the pros and cons for each scenario.
What is a “put” option?
Purchasing a put is the right to sell grain at a desired price. That price is called the strike price.
Why would farmers purchase puts?
Farmers purchase puts to guarantee a floor price for their grain. Purchasing puts allows for unlimited upside potential if the market rallies, but protects farmers if prices fall below a certain price point. Also, there is no risk of margin call purchasing puts, but they do require paying for this right up front.
This sounds great. A floor price with unlimited upside potential sounds like a very safe and low-risk option. Purchasing puts has several benefits, so often brokers will suggest this option to farmers by first showing risk assessments where corn could potentially hit $3 in the future (I don’t disagree with that assessment). Such low prices can frighten farmers, and this option can help minimize fear. So in many cases, brokers will recommend purchasing puts for a large percent of a farmer’s production early in the marketing cycle to 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 puts?
I’m not against purchasing puts, but farmers need to be very clear on all the advantages AND disadvantages when using them.
Note: there are two common practices when purchasing puts that farmers need to realize that have a big impact on the profits gained from purchasing puts.
- A common recommendation by brokers after purchasing puts is to “roll up” puts as prices increase (typically in 30 cent increments) to increase their floor price, since no one knows when the market top will be hit or at what price it will be. Farmers need to understand that there is a cost in doing that, typically it costs about 10 cents for every 30-cent increase of protection.
- When rolling up puts, the strike prices usually needs to be 20 cents LESS than where futures prices are at any given time. The reason: if a farmer purchased a put close to futures prices the cost verses the expense would be MUCH higher (i.e. more than the 10 cents to roll up a 30 cents gain).
Following provides several realistic situations where farmers may consider purchasing puts and how the prices they receive are impacted by this strategy:
A farmer purchases a $3.50 put when futures prices are near $3.80.
A farmer purchases a Dec ’17 $3.50 put for 15 cents (this was available recently), when the futures were around the $3.80 level. When the futures price hits $4, the farmer rolls up the put from $3.50 to $3.80 for 10 cents.
On the surface this looks like a good thing, but often farmers don’t take into consideration the expense of purchasing puts (in this case 15 cents plus the additional 10 cents for rolling the put from $3.50 to $3.80). So the $3.80 floor is actually $3.55 after including the cost of the put.
If this ends up being the highest price for the year, the farmer basically had to settle for $3.55, most likely an unprofitable price point even though at one point the farmer could have had $4 (most likely very near a profitable price point). So in this scenario, purchasing puts didn’t really help the farmer, and at worst actually hurt them.
Corn rallies to $5 this summer. Let’s assume the farmer continues to “roll up” the puts as the market rallies to $5.00 (i.e. after the $3.80 roll up next to $4.10, then $4.40, then $4.70). This would mean the $3.50 put (originally) will be rolled up $1.20 to $4.70. BUT, the farmer also has the expenses of purchasing the puts plus the cost to roll these puts 4 times:
- Original put purchase – 15 cents
- Roll up $3.50-$3.80 – 10 cents
- Roll up $3.80 to $4.10 – 10 cents
- Roll up $4.10 to $4.40 – 10 cents
- Roll up $4.40-$4.70 – 10 cents
- Total expenses for purchasing puts: 55 cents
In other words, the cost to have the floor price was 55 cents off the final floor guarantee price ($4.70 – 55 cents = $4.15). While $4.15 is likely a profitable price for most farm operations, the put expenses took a big bite out of the farmer’s potential profits as prices hit a high of $5.00. Again, in this scenario the farmer didn’t benefit much from the purchased put or the unlimited upside potential of the market.
Similar to last year, prices go to $4.50 relatively quickly (but few farmers sell thinking prices will hit $5).
In this case, the highest put floor that could have been purchased was likely $4.10. Now there is a chance the farmer decided to spend 7 or 8 cents to roll up 20 cents for more coverage to $4.30 thinking that $4.50 was the top, but this would be extremely unlikely. Usually farmers won’t change their strategy when they feel upside potential is still huge.
This means that if a farmer started with a purchased put at $3.50 (as in the example above) and rolled up every 30 cents, the maximum floor potential this farmer would have purchased was $4.10. After the purchase expenses (15 cents + 10 cents + 10 cents = 35 cents) the floor price is actually only $3.75. This price is most likely unprofitable for most farmers and a hard pill to swallow when nearly $4.50 was available to trade.
Farmers don’t roll up puts to increase floor price
For this scenario, I ask, “what’s the point of purchasing puts and rolling up then if I don’t make any money doing it? I will just buy the put and not roll up at all.” Let’s assume a farmer’s breakeven is $4. If the farmer doesn’t roll up, buying a $3.50 put is useless because their true floor after the put is $3.35 This particular farmer might do better just holding the grain and waiting for prices to just increase and sell at least ½ of their grain at $4.00 or $4.20 and gamble with the balance. This seems like the worst idea of all of them on this list.
What is the impact on put purchase strategies when farmers scale up sales (i.e. selling grain in increments as the market rallies above their cost of breakeven)?
Let’s assume the farmer will start selling 10% of his production when prices hit $4.20 and will continue to sell 10% every 10-cent increase after that (i.e. scaled up selling). This is when the brokers typically recommend that a farmer SELL the purchased puts back to minimize total put expenses on the scaled-up prices.
It’s important to remember that puts lose value as the market rallies and the SELL price of a purchased put is far less than what was paid in an up trending market. For example, if the market is at $4.20, (assuming there was a roll to $3.80) that put has at least 25 cents cost in it. When the farmer goes to sell their put at the point of the $4.20 sale, it’s likely the value at this point would only be 12 cents. So the value of the future sale would be $4.07 ($4.20 – 13 cents). While this is profitable for most farmers, it isn’t as great as what it seems when making that $4.20 sale.
If futures rally to $4.50, let’s assume the farmer rolled up at $4.10. With the $4.50 futures sale, the final price would be worth $4.33 ($4.50 – 35 cent put price + probably 17 cent on the put sell back). This isn’t necessarily a bad trade, as long as the farmer fully realizes the expenses associated with it and the actual real price they get. But recall that last summer futures only went to $4.495. Many farmers missed this potential trade by a half cent and had to do the next trade.
Prices go up and puts get rolled up. Then prices start going down without the farmer having sold.
I’ve seen some brokers get creative when this happens, advising farmers to start rolling the puts DOWN to potentially add profit. The theory is to try and bank some profit on the puts as the market goes lowers and hits bottom. Then they hope for the market to go back up significantly to add extra money. Usually they suggest to roll down for a collection of 2 cents for every 3 cent move.
Continuing with the example above, if prices go from $4.10 (with a purchased put and roll of 35 cents costs) to $3.50. They will sell their $4.10 put and repurchase a $3.50 put at a premium of 40 cents for this 60 cent move This would mean a 40 cent profit, capturing 2 out of the 3 cents in the put move. However there was a cost of 35 cents to get to this point and after all the trading the farmer has 40 cents of profit in one trade but only a net of 5 cents and no grain is sold and futures are at $3.50. Granted the farmer has a free $3.50 floor, but that doesn’t seem very exciting.
While I’m not against this type of creative trading, it’s important to realize that it adds risk to the farmer. It is assuming that the low will hit and a rally will follow soon. That is not something we saw last year or are expecting this year. Plus, rolling down puts reduces the protection in place. Again, I may consider allocating 5% to10% of production for this kind of trade. However, I’ve seen farmers who were advised to allocate a high percent of their production — some brokers have advocated 80%+, which would make me uncomfortable after looking at several different ways that this won’t pan out.
When does it make sense to purchase puts?
The best scenario for purchasing puts is when the market moves to extreme ups quickly (i.e beans last summer). Long-term sideways markets are bad for put purchasers. Looking back historically, when I’ve done this type of trade, it has tended to be the least profitable of all trades for the year. This is why I usually avoid it or allocate a very small percent of my production to just out right purchasing puts.
Options are great tools for farmers. But when you are promised something that sounds too good to be true, it probably is. Too often farmers are lured into doing these trades with dreams of trading at the top of the market while having downside protection. Also, having no margin-call is a bonus. Farmers need to realize — there is no magical position farmers can put on that will guarantee the top, while providing downside protection. If there was EVERYONE would want that.
The question that farmers need to ask themselves is “what is their overall grain marketing goal?” The answer of, “to make as much as I can,” is not a marketing plan.
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.
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