Melvin Brees
Farm Management Specialist
University of Missouri Extension

 

 

 

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Please send your comments and send suggestions to Melvin Brees, Farm Management Specialist, University of Missouri Extension, #1 Courthouse Square,  Fayette, MO 65248, call 660-248-2272, or send messages by e-mail to: breesm@missouri.edu.
February 25, 2000

Are Options Awfully Expensive?

The buying of options as a "price insurance" strategy is often recommended by marketing analysts and newsletters. Purchase of a put option when you are holding (growing) grain "insures" against lower prices by providing an unobligated right to sell futures (hedge) at a strike ("insured") price. Buying a call, after (or when) you sell cash grain, "insures" against missing higher prices by giving you the unobligated right to buy futures (re-own on paper). These "rights" can remove a huge amount of risk and make marketing decisions much easier. The seller (writer) of the option assumes the risk. When the markets are volatile and uncertain, as they are now, the seller expects to get paid well for taking the risk. This can make options appear awfully expensive.

Are options expensive now? To answer that question, you just need to evaluate the risk and "do the math." Then you can decide whether the "insurance" is worth what it costs to avoid the risk. Let's look at a current example that assumes you have old crop ('99) soybeans in commercial storage at three cents per bushel per month. Also assume that you would like to maintain ownership until July, to take advantage of rallies that might occur if the weather stays dry, and will pay 10% interest on borrowed operating money.

Thursday's (2-24-00) Central Missouri cash soybean bids averaged about $4.86 at selected locations. If you store these "$4.86 beans" until July, the storage and interest costs amount to $0.35 per bushel. Selling the soybeans for $4.86 would eliminate these storage charges, you would have cash for operating expenses and you would eliminate the risk of lower prices. The problem is that weather conditions are very uncertain and, if it stays dry, you might miss out on significantly higher prices--which you really need!

In order to be in a position to capture higher price, you could buy an August call option. Since the August call expires in July, this would give you the right to re-own the soybeans on paper until July--the same period that was considered for storage. The August soybean futures contract closed at about $5.23 on Thursday. The $5.25 (strike price) August call premium (cost) was $0.34 1/2. With broker charges and interest on the premium, the cost per bushel would be almost the same as the potential storage cost of $0.35!

Small price rallies between now and July might be harder to capture with the option due to what is referred to as the "delta." Delta describes how option premium movements don't equal futures price changes, especially when there is considerable time left before the option expires. However, if it is a significant price move that you don't want to miss, the option will accomplish most of that with much less risk than continuing to store cash soybeans. Remember, with good weather, prices could decline which would add losses on top of the cost of storing. It may seem expensive, but the call option might accomplish the same objective at a cost that compares favorably with the cost of commercial storage.

-- Melvin


University of Missouri ExtensionDecisive Marketing - February 25, 2000
http://outreach.missouri.edu/agconnection/DCT/DM000225.html -- Revised: April 20, 2004
breesm@missouri.edu