Using Price Insurance

Heather Moffatt, Grain Risk Management Advisor, Agricultural Marketing First

Agricultural producers face many risks in their businesses. Some are unforeseen and can be financially crippling but many of these are manageable. Two major financial risks that come to mind are production and price. Crop Insurance is widely used to protect against a crop shortfall or sometimes what could have been a devastating disaster.

Price insurance works similarly. Price insurance is a great tool but because it is viewed as complicated is option coverage can do for your farm
business.

In theory, protecting high prices with put options (downside insurance) on unsold grain sounds like a great idea. It’s “insurance” that can be collected upon if necessary. Buying call options (to participate in further futures strength) after making a sale also seems like a great way to stay “in the market” agricultural option quotes. There are a lot of them trading over various futures months. If you’re buying puts to protect grain in the field, yet to be planted or harvested, you’ll probably look to December for corn, November for beans and either July or September
for wheat. If you have grain in the bin, not yet shipped, you might look a couple months forward into your anticipated shipping month to buy put coverage.

Choosing a month to purchase call option coverage can be more difficult. It’s nice to buy calls which provide you with time but for any of you who have traded options, or followed them, you know time can be expensive. Time becomes your enemy if you are a buyer. First, consider what strike price you would pick and why. Buying a call option at–the-money, or very close to the price at which you sold your grain, would be a logical choice. Unfortunately, these options can be subject to the most volatility hence the most expensive. Ask yourself why you’re buying a call option. Is it in the event prices go up 20 cents, 50 cents or $1.00? Rather than looking at options as penny for penny price insurance
consider them as “disaster insurance”. If you sell soybeans today, March soybeans are trading at $7.40 and May soybeans $7.55. A $7.60 May call, relatively close to the underlying futures price is $.29. If prices drop as time progresses or stay flat, the premium will erode to nothing. If
prices rally, May beans need to trade over $7.89 (your strike price plus the premium) to start clearing a profit. If you sold beans and then prices move 30 or 40 cents, you probably won’t be too upset for selling too early. If beans rally $1.00 or more you’ll probably be somewhat more annoyed. With that in mind, a May $8.00 call is $.16. It isn’t a huge investment, but would provide good coverage if the market really
appreciated. Your option will expire on April 20th and at that time you will have to decide whether or not to extend coverage further. Herein enters the time considerations. Beware……just the time you exit, the market prices will rally. If you want to stay in the market to participate in potential crop scares as the season unfolds, buying further coverage will be necessary. Try to avoid buying options in times of increased volatility, hence inflated premiums.

Take note of the reasons for buying an option and calculate the final outcome of that “insurance”. If you buy a put option to protect against a
possible decline in futures values and it expires worthless, compare the “pros and cons” of your strategy. If your put expires worthless that means futures prices didn’t dip below your strike (support) price. It would mean cash prices have traded higher, and you didn’t need the put. Wouldn’t you rather give up the option premium, yet have much higher cash prices? If you sell crop and buy a call and the call expires worthless, what just happened? You, in all likelihood, sold cash at high values, the price dropped and the option expired worthless. Maybe the
ability to stay in the market with a call option gave you the impetus to make the sale? If you sold at the top of the market, then subtract the call premium, your cash price should still look attractive. Losing option premiums isn’t always a bad thing when you compare all aspects of the strategy.

Using options on futures is a tool that producers can utilize. They often get a “bad rap” because we don’t compare all sides of the strategy.
Sometimes not collecting on your “insurance” isn’t a bad thing. Would you rather have 50 bushels of soybeans per acre or 13 and collect insurance? Consider options the cost of doing business. Staying in the market whether it’s by paying storage at your elevator, the cost of carrying grain in your bin or purchasing option coverage entails costs. Take the time to compare all costs and fairly compare your strategies.