Starting Simple with Risk Management12/26/2018
It was just a year ago when I wrote two articles about the merits of buying inexpensive put options as a way to minimize the price risk of owning and growing crops. Of all the various risk management strategies growers are presented with, buying an inexpensive put option has to be the one of the easiest, no-hassle ways of taking risk off the table that I know of, and yet, many still balk at doing it.
The example I offered a year ago talked about the benefits of buying a December 2018 corn $3.20 put for two cents a bushel. When the article was published on Dec. 19, December corn was trading at $3.81 and the DTN National Corn Index of cash prices was at $3.09.
Many at the time, were talking about selling the December 2018 corn futures contract as a hedge, because the new-crop price was so high above cash. I am generally not a fan of capping prices at this time of year, knowing that cash corn typically makes seasonal highs before early June.
Buying the put not only took 84% of the risk of owning corn off the table, it also allowed the holder time to benefit from a chance for higher corn prices, should corn’s seasonal tendency prove out as it often has in the past.
Going with the put in late December instead of committing to an early sale proved the better choice. When DTN Market Strategies recommended making forward cash sales on 50% of corn production on April 30, December 2018 corn futures had risen above $4.00 and the DTN National Corn Index was at $3.63 — higher prices than those offered in December.
Some have asked, why buy puts when we have crop insurance? That is a fair question.
Crop insurance is the better first choice because of its broader protections, but there are also reasons to check the prices of put options. The first is that, during the winter, price volatility is low and you can often find inexpensive puts that provide higher levels of price protection that do not interfere with crop insurance benefits.
The second reason is that owning put options gives you more flexibility than you get with crop insurance. For example, if corn prices fall to $2.80 in August, you can sell your put options for a profit in August. Your crop insurance provides protection, but only based on prices and yields in the fall.
It is also important to understand that crop insurance coverage is based on revenue, which means the price protection drops in years of higher yields. With put options, your chosen level of price protection does not change, allowing you to stay protected and benefit from higher yields.
As I have thought about why producers are reluctant to buy puts, I’ve noticed that framing makes a big difference. In other words, because we buy put options from a brokerage firm instead of an insurance agent, we tend to look at their purchase as a speculative investment and judge the outcome by whether the option itself made or lost money in a given year.
Most of us would be better off if we started looking at puts the same way we buy homeowners insurance.
No one bothers to check the weather forecast before they buy homeowners insurance. And I’ve never heard anyone get upset about losing the premium when their house didn’t get hit by a tornado. We tend to regard homeowners insurance as a 30-year or more commitment and we don’t expect to make money off of the premium payments.
We understand that over several decades, a major loss could happen, and so we are willing to pay a certain amount to prevent it. Nobody likes paying for insurance, and I don’t recommend loading up on insurance for your home or your grain. Just consider buying enough to obtain some cheap protection.
In the case of put options, we actually have some control over the prices we pay, and we help ourselves by shopping in winter when price volatility is low — or we can pass and wait for another day. But it only makes sense when we understand all the benefits and risks involved.
Here are two candidates to consider for new-crop protection in 2019:
A December 2019 $3.40 corn put, preferably below 3 cents.
A November 2019 $7.80 soybean put, preferably below 4 cents.
Comments above are for educational purposes only and are not intended as specific trade recommendations. The buying and selling of grain futures and options involve risk and are not suitable for everyone.
Source: Todd Hultman, DTN/The Progressive Farmer