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RMEY065 Using Options To Price Stored Crops
MAIN IDEA: How can I ensure a minimum price return on a crop held in storage?
Poor prices at harvest time often encourage farmers to store their crops in hopes of a spring rally.
** But if a farmer stores the crop in hopes of a price rise but prices fall, the farmer receives a lower price AND has to pay storage costs.
** Or, a farmer who forward prices at harvest, using a futures hedge or forward contract, will miss out on the potential of a strong price rally down the road.
OPTIONS OFFER A THIRD ALTERNATIVE. Options can be used to hedge against potential price declines without sacrificing the potential for a price rally through the winter or spring storage season.
Imagine that it is harvest and soybean prices are above the cost of production. You think there is still a chance for higher prices, but you want to protect against declines over the next crop year. You buy a PUT option, with a STRIKE PRICE that will give you a profitable net return.
The option contract entitles you to receive a short futures contract at the strike price. That means it can provide you with a price for your crop that is equal to the strike price less the basis at your local market. In exchange for that guarantee, you pay a PREMIUM (like an insurance premium).
If prices go higher, you forget about the option. You have no obligation to sell at the strike price. At the same time, you sell your crop at the higher price. You have lost only the amount of the premium.
But if prices decline into the spring, you have two choices:
- YOU CAN "EXERCISE" YOUR OPTION. You would call your broker and say, "I'd like to exercise my contract." You will automatically be assigned a short futures position, at the strike price. Of course that is a profitable position since prices have fallen, so you can buy back your futures position and add those hedge profits to your cash selling price.
- YOU CAN "OFFSET" YOUR OPTION. In this case, you would call your broker and say, "I'd like to sell a put." In return, as a seller of the put, you will receive the premium. As you have now bought a put and sold a put, you have canceled out any position in the options market.
To offset your original purchase of the put, you must sell a put at the same strike price as the one you purchased. Of course, since prices have declined, premiums for that strike price will be higher than the one you originally paid. Your options profit is the difference between the premium you originally paid and the one you eventually receive. Add that to your cash selling price to figure out a net selling price.
A vast majority of hedgers will offset, rather than exercise their options. Commission costs are lower and it is a simpler procedure.
STORAGE HEDGE EXAMPLE
Here's a numerical example to illustrate the strategy. It is November. May soybean futures are trading at $6.51. You buy a $7 put option for a premium of 66 cents to protect against a price decline. Typically your basis is 30 cents in the spring.
The target price for your hedge is strike price, less premium, less basis. In this case it would be: $7.00 - 0.66 - 0.30 = $6.04. Remember, this is your minimum price.
Early year demand for beans lags. May futures fall to $6. Now you sell a put option with a strike price of $7, which now commands a premium of at least $1. This is equal to the INTRINSIC, or built-in, VALUE of the option.
You now have NO position in the market. Add the net gain in the options market of ($1 - 66 cents) = 34 cents to your cash selling price of $5.70 and your net effective price is $6.04. No matter how low prices had fallen you would have been guaranteed that minimum price.
But what if a drop in the value of the dollar boosts exports and May beans rally to $9? You would simply have let the put option expire. Subtracting the 66 cent premium from your cash selling price of $8.70 would give you an net effective price of $8.04.
EXERCISES:
1. It is November. You buy a put option on May wheat with a strike price of $4.00 for a premium of 20 cents a bushel. Calculate what happens if May wheat futures prices fall to $3.50. Your basis is 20 cents. What is your net effective price?
2. Use the above example. What happens if May wheat futures prices rise to $4.50? What is your net effective selling price?
3. Situation: Assume you have storage space available for 15,000 bushels of corn. Typically the basis at your local markets is -25 cents at harvest and usually gains to around -10 cents by July. Meanwhile, you could earn 6 percent interest on a six month certificate of deposit at your local bank.
- Find future quotes and options premiums for corn.
- Using current markets, determine what net effective price per bushel you could expect from each of the following for your 15,000 bushels of corn:
A. Sell at harvest and leave storage empty.
B. Store and hedge with July futures.
C. Store and hedge using a put option on July futures.
- How many extra dollars could you earn by selecting the best way to market your 15,000 bushels of corn?
Note: You may want to refer back to lesson RMEY064 Pricing Grain Held in Storage to help you calculate answers to part A and B above.
INTERNET RESOURCES:
** Chicago Board of Trade - agriculture futures quotes
http://www.cbot.com/cbot/www/page/0,1398,12+29,00.html
** Chicago Board of Trade - ag options quotes
http://www.cbot.com/cbot/www/page/0,1398,12+30,00.html
TEST:
1. Suppose you buy a put option on May soybeans at a strike price of $7.00 for a premium of 30 cents. Your basis is 25 cents. What is your minimum guaranteed price?
2. In the example above, what is your net effective price if May beans fall to $6.50?
3. In the above, what is your net effective price if May beans rally to $8?
4. If you offset a put purchase by selling a put at the same strike price, that position can be exercised against you. TRUE or FALSE?
5. Most farmers will take their options profits by exercising the option rather than offsetting it. TRUE or FALSE?
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Copyright © 2001 Stewart-Peterson, Inc. All Rights Reserved. RF/nc 105160
END STUDENT SECTION
RMEY065 Using Options To Price Stored Crops
TEACHER'S GUIDE
OBJECTIVE: Students will be able to use current price quotations to calculate a floor price that could be established on a stored crop through the purchase of put options. They also will be encouraged to compare results of using options vs. futures or cash contracts to establish prices on stored crops.
PREPARATION: Review lesson RMEY064 Pricing Grain Held in Storage as a refresher on options and storage hedging. Be ready to answer student questions. Help them to find quotes required for exercise #3. Useful Internet sites are listed under Internet Resources.
INTERNET RESOURCES:
** Chicago Board of Trade - agriculture futures quotes
http://www.cbot.com/cbot/www/page/0,1398,12+29,00.html
** Chicago Board of Trade - ag options quotes
http://www.cbot.com/cbot/www/page/0,1398,12+30,00.html
IMPORTANT TERMS: put, strike price, premium, exercise, offset, intrinsic value.
EXTENSION: Have students construct a marketing plan for a crop that is being held in storage. They should use current price quotes and describe what they would do under various price outcomes. Discuss the advantages of options versus forward contracting or hedging on the futures market. Challenge them to consider the merits of a "minimum" floor price, vs. a locked-in hedge.
EXERCISE ANSWERS:
1. Net effective price is futures price, less basis, plus options gain, less options premium. The intrinsic value of the $4 put option is at least 50 cents when the underlying futures is $3.50.
Thus, the answer is: $3.50 - .20 +. 50 - .20 = $3.60
2. The option should be allowed to expire. The net effective price is futures price less basis, less options premium.
Answer: $4.50 - .20 - .20 = $4.10.
3. Answers can be determined as follows:
A. Harvest time delivery is December futures less 25 cents basis. Example: If December futures is $2.59, cash delivery price is $2.34.
B. Net target price is July futures, less 10 cents expected basis, less storage costs. Example: If July futures is $2.76, and basis is 10 cents, net price received is $2.66. In addition, student should deduct storage opportunity cost. Six months interest on $2.59 corn is about 8 cents.
Example answer is: $2.76 - 0.10 - 0.08 = 2.58.
C. Minimum target price is option strike price less premium, less basis. Example: Buy a July $2.90 put for a 40 cent premium. Net price is $2.90, less 40 cents, less 10 cents equals $2.40. Storage cost is the same as above.
Example answer is: $2.90 - 0.40 - 0.10 - 0.08 = $2.32
These three choices can add up to a major difference in returns on 15,000 bushels. Net revenues for answer examples used are:
A. 15,000 x $2.34 = $35,100
B. 15,000 x $2.58 = $38,700
C. 15,000 x $2.32 = $34,800
Bottom line: In this example, the producer could have earned nearly $4,000 more by taking the time to calculate the difference among marketing alternatives. However, be sure to remind students that the options target is a "minimum" price guarantee, while the contract and futures hedge are a maximum.
Should prices turn higher, alternative C allows for additional gains. Example: If futures climb to $3.20 the option is allowed to expire and the net price is $3.20 - 0.10 - 0.40 - 0.08 = $2.62. Total revenue is $39,300.
TEST KEY:
1. Suppose you buy a put option on May soybeans at a strike price of $7.00 for a premium of 30 cents. Your basis is 25 cents. What is your minimum guaranteed price?
Correct calculations are strike price, less premium, less expected basis:
Thus, the answer is: $7.00 - .30 - .25 = $6.45
2. In the example above, what is your net effective price if May beans fall to $6.50?
Correct calculations are futures price, less basis, plus options gain.
Thus the answer is: $6.50 - .25 + (.50 - .30) = $6.45.
Options gain is intrinsic value less premium: $7 strike price, less $6.50 futures, less 30 cents premium.
3. In the above, what is your net effective price if May beans rally to $8?
Correct calculations are futures price, less basis, less premium. The options is allowed to expire.
Answer: $8 - .25 - .30 = $7.45
4. If you offset a put purchase by selling a put at the same strike price, that position can be exercised against you. TRUE or FALSE?
FALSE. Purchasing and then selling an identical put takes you out of the market. However, if you sell a put or call that are not offsetting a previous purchase, they can be exercised, putting you into a losing futures position.
5. Most farmers will take their options profits by exercising the option rather than offsetting it. TRUE or FALSE?
FALSE. It is less costly to offset than to exercise. Few options are actually exercised.
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Copyright © 2001 Stewart-Peterson, Inc. All Rights Reserved. RF/nc 105160
END TEACHER'S GUIDE
Questions?
For more information call 800-361-5199.
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