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.
March 17, 2000

Disappointing Option Outcomes

Buying put options to set minimum prices (insurance against lower prices) or call options to offset pre-harvest sales (insurance against missing higher prices) can be excellent risk management strategies. However, sometimes these strategies don't perform as well as hoped--why?

The option premium is an expense and sometimes they are costly. The option seller (writer) assumes the risk, allowing the buyer the right to enter the market at a fixed price, regardless of what prices do. For assuming this risk, the seller gets to keep the premium. This premium, in effect, reduces the "insured" or minimum price by the amount of the premium.

When option premiums are expensive, they can cause a significant reduction in the minimum price. For example, on Thursday (11-16-00) November 2000 soybeans closed at $5.46. This is well above the $4.25 average price that some have forecast for new crop soybeans and might be a good price to protect (insure). A $5.50 (strike price) November soybean put option had a premium of about fifty cents. Subtracting this fifty cents along with a possible harvest basis of about minus thirty-five cents results in a minimum cash price is only $4.65 ($5.50 strike-$0.50 premium-$0.35 = $4.65). The strategy still works. The minimum price is above $4.25. But the results are disappointing because the premium cost significantly reduced the minimum price.

Changes in option value may not offset price changes. Daily futures price changes are usually greater than change in option value for the same contract--especially for at-the-money and out-of-the-money options. This difference in price change is referred to as the Delta. An at-the-money option (like the above November $5.50 put) often has a delta of .5. A Delta of .5 suggests that there is a 50/50 chance of prices going either way or a 50% chance that the option will be exercised. If soybean prices decline ten cents, the $5.50 November put option with a Delta of .5 would only increase in value by five cents.

For further out-of-the money (cheap) options, the Delta would be even less. As an option moves into-the-money, the Delta becomes greater and eventually the change in option value equals the change in futures price. However, it may take a significant price move into-the-money before the option gains offset the initial premium cost and reflect actual price changes.

It is important to understand that options aren't a "perfect" strategy. They can function as price insurance and, like insurance, they cost money. Buying options also works better when price moves are large or premiums are low. Deciding whether to buy them can sometimes come down to what is affordable. However, options can provide protection against the big risks (serving as a back-up strategy or insurance). This protection can make pre-harvest marketing decisions much easier in high-risk markets.

-- Melvin


University of Missouri ExtensionDecisive Marketing - March 17, 2000
http://outreach.missouri.edu/agconnection/DCT/DM000317.html -- Revised: April 20, 2004
breesm@missouri.edu