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Don Hofstrand Revised October 2006
Co-Director – Ag Marketing Resource Center
Iowa State University
dhof@iastate.edu |
During periods of high prices, farmers are often interested in forward pricing crops.
However, many are concerned about using forward cash contracts, hedge-to-arrive contracts, or hedging for fear that prices may go even higher. Buying put options would relieve these worries. But premiums to buy puts rise sharply as prices become more volatile.
Building a Fence
Building a fence by using options is an alternative you might want to consider. By building a fence around your net price, you set a minimum price under which the price cannot fall and a maximum price over which the net price cannot rise. To build a fence you buy a put option with a strike price just below the current future price and sell (write) a call option with a strike price above the current futures price. The put option establishes a floor price for your grain. The call option establishes a ceiling price.
The cost you pay for the fence is the put option premium plus option trading costs. There may also be interest on margin money for the call option if price rises. However a portion of these costs are offset by the premium you receive from writing the call option.
Example.
Assume November soybean futures price is $10 per bu. because of severely dry conditions in the corn belt. The strike prices and option premiums are:
Strike Premiums
Price Calls Puts
$9.75 $1.15 $ .77
10.00 .98 .88
10.25 .89 1.05
10.50 .78 1.21
10.75 .72
11.00 .67
A $10 strike price put premium is 88 cents. Selling a $10.50 strike price call premium is 78 cents. The net premium cost is 10 cents/bu.
($.88 - .78 = $.10). |
Minimum Selling Price
The minimum selling price from the fence is the strike price of the put option, less the net premium cost, less the options trading costs, less the basis.
In the example, the minimum price from the fence is the $10 put strike price, less 88 cents put premium, plus 78 cents call premium, less 5 cents for trading costs, less a 50 cents basis, or $9.35.
Example.
Assume the expected basis is 50 cents and the trading cost is 5 cents.
Put strike price $ 10.00
Put premium - .88
Call premium + .78
Trading cost - .05
Expected basis - .50
Net price $ 9.35
Assume November soybean price drops to $7 at harvest and the actual basis is 45 cents. You exercise the put option which places you in the futures market at $10. You buy back that position at $7 for a $3 futures gain. At the same time you sell your cash beans for $6.55 (actual basis is 45 cents under November futures). Add the $3 futures gain, and the 78 cent call premium to the $6.55 cash price. Then subtract the 88 cent put premium and the 5 cent trading cost. The net price is $9.40. The net price is 5 cents higher than expected price ($9.35) because the basis is 5 cents smaller than expected. |
Example.
Price decline—$7.00 Nov. futures
Put strike price $ 10.00
Nov. futures - 7.00
Futures gain $ 3.00
Cash sale futures $ 6.55
Gain + 3.00
Call premium + .78
Put premium - .88
Trading cost - .05
Net Price $ 9.40
The results would be about the same if you sold your put option to someone else rather than exercising it. The call option will expire worthless. |
Maximum Selling Price
The maximum selling price from the fence is the strike price of the call, less the put premium, plus the call premium, less option trading costs, less the basis.
Example.
Maximum Selling Price
Call strike price $ 10.50
Put premium - .88
Call premium + .78
Trading cost - .05
Basis - .50
Net Price $ 9.85
Assume at harvest November beans are $12.50. Cash beans rise to $11.90. The actual basis is 60 cents under November. The call option for $10.50, which you sold (wrote), is now worth $2 to the call option buyer. So, the option may be exercised by the call option buyer. If so, you have to sell the buyer November futures for $10.50 and buy back the position for $12.50 for a $2 loss. The results would be about the same if you bought the call option back for a loss. |
Example.
Price rise - $12.50 November futures
Call strike price $ 10.50
Nov. futures - 12.50
Loss $- 2.00
Cash sale $ 11.90
Loss - 2.00
Put premium - .88
Call premium + .78
Trading cost - .05
Net Price $ 9.75
You sell your cash beans for $11.90. After making the adjustments the net price is $9.75. That’s 10 cents less than the maximum expected selling price because basis is 10 cents wider than projected. The put option expires worthless. |
Below are minimum and maximum selling prices at various put and call strike prices.
Options fence at different strike prices
Remember, if you’re writing call options and the market goes up, you have margin calls. The increased value of the crop offsets the margin calls. However, you need to pay the margin calls before you receive cash from the sale of the grain. So you need to make arrangements with your lender to cover margin calls.
* Reprinted with permission from Ag Decision Maker, Iowa State University Extension