Are options the answer?

The market is unsure if bean tariffs will mean anything. Even if China starts buying all of their beans from South America, the rest of the world could still buy U.S. beans. This week the Brazil bean cash offers skyrocketed off the tariff news, but when the futures came down 50 cents other world buyers started buying U.S. beans, as they were the cheapest globally. This is likely why the markets dipped and then recovered shortly after.

Reduced Argentina production is bullish, while U.S. bean stock levels are bearish. It’s still uncertain how many acres U.S. farmers will plant. I expect a roller coaster ride ahead for the bean market.

If corn demand continues to stay steady or increase, prices likely will be strong and have upside potential. If demand were to decrease, so will prices. Weather will start to be an issue in three weeks and could help determine if additional acres will be planted from the USDA estimates.

 

Are options the answer?

Last year caught many farmers off guard, because it was the first time in a while that average farmers didn’t have an opportunity to sell an average crop at profitable levels. Many farmers are fearing 2018 will be the same. Therefore, some farmers want to consider alternative solutions (like options) to increase their profit potential, but don’t know how. While I don’t think options are a cure all strategy, if used in moderation and as long as farmers understand all of the risks, they can help farmers take advantage of more opportunities and increase flexibility in their marketing plans.

For the first time in the last 10 years I had more than 35% of my production tied up in options trades in 2017. But, 2017 was also the first time in 10 years that corn didn’t trade over $4.30 before harvest. Sometimes market conditions force me to consider alternative strategies to maintain profitability for my farm operation

Grain marketing with good risk management practices is a very complex process. The best marketing plans need to constantly adapt to market variances. With more flexibility and trade choices (including options), farmers can maximize profit potential. Conditions affecting prices change every year, so marketing plans need to adjust too.

Too often farmers have the market strategy “I want to get the most I can.” This “plan” isn’t a plan. It assumes one can predict the top of the market every year, which is impossible. Instead, I prefer setting price goals I’m willing to accept that meet my farm operation’s profitability objectives.

Below I’ve provided some examples of different options that I’ve used or considered in the past and the pros/cons of implementing them into my marketing plan.

 

Selling call options

Selling calls gives the right to someone else to buy my grain from me at a certain price. When selling calls I get a premium regardless of how the trade turns out. If the price at expiration is the same or higher than the strike price of the call, I have to sell grain for the strike price, but I also keep the premium. If the price is below the strike price at expiration, no sale is made, but I get to keep the premium to add to a later trade.

Since grain producers ALWAYS have more grain to sell, selling calls is a natural hedge trade for farmers. It doesn’t allow for much upside price potential and provides limited downside protection, but it can be very useful during sideways markets. In the last year selling calls has allowed me to pick up added premium on some of my grain, while prices remained at unprofitable levels.

 

Selling put options

Selling puts gives away the right to someone else to give me grain at a certain price.

This type of trade is extremely risky for grain producers because it places them in a position of potentially being forced to buy grain at higher prices when they always need to be selling their grain. There are few cases where this type of trade by itself would make sense for a grain producer and I think should be avoided.

 

Selling straddle options

Selling straddles are when I sell both a call and a put at the same strike price and collect both premiums. Generally, this type of trade is most profitable in sustained sideways markets. While I usually avoid selling puts, the one exception is when I sell a call at the same price (i.e. selling a straddle).

While I have had considerable success with straddles over the last 16 months, I had never even placed a straddle in the previous 8 years. Back then I couldn’t justify the potential risk of having to buy grain back if the market fell far enough for the potential premium I would get if the market remained stagnant.

To sell a straddle, I select a price I think corn will be at on a specific date in the future. If futures prices are at that price on the selected date, I keep the total premium generated from the trade. The further the actual futures price is from the strike price I picked on the last trading day of the straddle, the less premium I collect until it the straddle hits certain price points in either direction. Those points are derived from the strike price and the total amount collected for selling the straddle. From there, I’ll either have to remove a sale (i.e. buy grain back) or make an additional grain sale.

In the last year I could justify this trade to myself and my banker because I first sold some grain at levels that were below the cost of production, so not very good sales to begin with. I didn’t think prices would likely go much lower and there was a reasonably high chance prices would go nowhere, or maybe higher. That initial grain sale provided a “security blanket” to place the straddle trade. If I didn’t really want to make a sale in the first place at the price I did, then the straddle would enable me to buy back the grain at lower prices. If I was going to sit with unpriced grain in the bin anyway, why not be willing to make money regardless of what happens. I discussed the trade with my banker prior to placing it, and he could also see the reason why I would do this type of trade on a few bushels.

While there are some advantages to straddles, there are some disadvantages. I wouldn’t commit a large percent of my production to this strategy because it first requires selling some bushels at unattractive prices to minimize my risk exposure. That means if the market ultimately rallies significantly, I get to double my sale at better portions because of the sold call portion of the straddle trade, but I still have the unattractive sale that minimized my risk exposure. Even if I wait to make the first sale at an attractive price level then I open myself up to potential downside in the market should the market drop significantly So, straddles have some draw backs and are certainly not a perfect trade.

While straddles can be profitable in certain market conditions, I need to be very cautious when placing them. Following are some best practices that I personally use when placing straddles to limit my risk exposure.

  • I never place a straddle trade without knowing every possible outcome that could happen and be willing to accept any potential scenario.
  • I almost never buy back either side of the straddle before they are within days of expiring. I have a strategy/plan in place and I was willing to accept all possible scenarios when I initially placed the trade, so changing in the middle could affect my profits and the outcome of other trades I have built around them.
  • Since these types of trades are generally more profitable in a sideways market, I go into the mindset of each trade hoping I made the wrong choice and prices go up, so I can sell more grain at higher prices.
  • I always have a sale already in place to protect me from the market dropping and having to reown some of my grain. This is why in the past I haven’t put straddle trades on because I don’t want to buy back profitable sales. Straddles, to this point, have only been a strategy I have used when prices were below the cost of production.

 

Buying puts

Buying puts means buying the right to sell grain at a specific price. I’m usually not a fan unless the strike price, less the cost of the put, is still above my breakeven costs. Even then it usually makes more sense to me to just sell the futures outright and guarantee my profit instead of hoping for higher futures prices.

For example, let’s say I buy a $4 put for 20 cents. This would mean my true floor price is $3.80. If my production cost is $4.20, then this trade guarantees I won’t be breaking even unless corn trades above $4.40. So, why even buy the put in the first place? I could just sell corn if it is anywhere above $4.20 and guarantee I’m going to have a profit.

Now, some would suggest rolling the puts up in a rally and back down in a decline to minimize this issue and add profits to the trade. But that adds costs on rallies, making break evens higher. Plus, if the market drops and farmers roll down the puts, it exposes farmers to more downside loss potential too. In theory these trades can be successful, but in sideways markets they tend to miss opportunity or lose money. Buying puts worked best during extreme volatility like 2010, 2011 and 2012. Over the past five years buying puts has provided a producer a floor price, but that doesn’t mean that the farmer was still profitable with the trade.

 

Buying calls

Buying calls means buying the right to buy grain at a specified price. I’ve never been a fan. Whenever I’ve done the math on buying call options, I find they are rarely, if ever, profitable for me. For buying calls to be profitable, it requires a lot of market movement to the upside. The thing is, I ALWAYS need the market to go higher for any unpriced grain I have left for this year or the next year’s crop, so I don’t need to double down on what I need the market to do anyway. This type of trade is too speculative for me when I’m trying to limit my risk exposure.

There are some who like to sell futures and buy calls. This is really just buying a synthetic put option, which I just described above.

Buying calls tends to sound best to those fearing they will miss out on a big futures rally. This type of trade is basically betting on a long shot. Yes, it has occasionally worked well like 2010, 2011 and 2012, but since 2013 it likely hasn’t been profitable.

 

What about options in the bean market?

I usually just focus my option strategy on the corn market and not beans, for the following reasons:

  • Beans have a lot of market volatility and uncertainty with South America growing 60% of the world’s beans. This means potentially two or three weather scares per year that can dramatically affect the market. Comparatively, about 75% of the world’s corn is grown in the northern hemisphere once per year (which greatly reduces market volatility potential).
  • Buying bean options, puts or calls, usually involves a large upfront fee. If I’m already profitable, I don’t see a reason to risk taking a loss hoping for better values. If the market does nothing but go down after buying the option I’m going to miss some opportunity as well.
  • Selling bean call options exposes me to huge price swings and doesn’t allow for me to sell if the market does rally even if I think the market is likely to fall down the road. Which means I don’t get much coverage to the downside.
  • I probably would rather buy beans options over selling them. The reason is because each crop trades differently. What works for corn doesn’t usually work for beans and vice versa. It’s incredibly hard to predict bean market movements and selling option strategies are usually less effective because of market inverses, while the initial upfront cost to purchase them can be a deterrent.
  • I also tend to use my bean crop as a hedge against my corn crop. If I can sell my beans for a guaranteed profit then all I have to worry about is weather my corn will make money. I want to know exactly where I am with my beans instead of wondering or hoping.

 

A balanced approach

I strive for a balanced marketing strategy that takes into consideration the market could go up, down or sideways. I want to take advantage of all opportunities available regardless of where the market goes, because it doesn’t always go up. I don’t fear missing out on a rally, because hitting the top isn’t my marketing goal. The fear of striking out and losses motivates me more than the thrill of hitting the very top of the market. I want to be in the upper end of the market trading range, but I need my farm operation to consistently be profitable and I’ll consider any opportunity that allows me to maximize profit potential while minimizing my risk. Using options prudently is one of many ways I can do this.

 

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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