Melvin Brees
Farm Management Specialist
University of Missouri Extension




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April 28, 2000

Reducing the Cost of Options?

November new crop soybean futures closed at $5.57 on Thursday (4-27-00). Assuming a Central Missouri fall harvest basis of minus thirty-cents, this suggests a harvest price of $5.22. While this price could be "locked-in" with a futures hedge or forward contract, there is still a lot of price risk in doing that. Harvest time prices could be much lower if the weather improves. What if the weather doesn't improve? This could cause much higher prices and reduce production--especially for cash contract delivery.

Options offer flexibility to deal with uncertain weather, production potential and markets. However, options can be expensive and this may make the option strategy seem unattractive. On Thursday, a November $5.50 (strike price) soybean put had a premium of forty-cents. Buying this put option results in a price floor of $4.75 ($5.50 strike price - $0.40 put premium - $0.35 basis). The $0.47 difference between the put strategy and a hedge or forward contract is due to the cost of the put ($0.40 premium) and the fact it is out-of-the money by seven cents ($5.57 futures vs. $5.50 option strike price). This difference makes the strategy unattractive, even though prices might very well be lower than this at harvest.

This situation often leads market advisors to look for ways to "cheapen" the cost of using a put option to set a higher price floor. There are a variety of possible strategies to accomplish this. One strategy, often recommended, is buying a put option and selling an out-of-the-money call option--sometimes referred to as "the fence." The idea is to collect the call premium and use it to offset part of the cost of the put premium.

In the above example, a $6.50 November soybean call had a premium of $0.20. This could improve the price floor by twenty-cents, raising it to $4.95 ($5.50 put strike - $0.35 basis - $0.40 put premium + $0.20 call premium). This strategy reduces the net premium cost, raises the price floor and still provides flexibility. There are no delivery requirements (as in cash contracts) and November soybean futures prices, at harvest time, above $5.50 would result in a net price above the floor price.

It is important to understand that selling the call also sets a price ceiling. At prices above $6.50 (Nov. futures), any price gains will be offset by losses on the sold (short) call option. This effectively limits net price to somewhere between $4.95 and $5.95 ($6.50 - $0.35 basis - $0.40 put premium + $0.20 call premium). It is also import to recognize that the short call position must be margined (just like futures). A severe drought, resulting in very high soybean prices, could result in significant margin calls or the option being exercised.

Market advisors are likely to recommend the "fence" and similar strategies (other combinations of buying and selling options) to manage price risk this year. The above "fence" sets a price floor that is better than just buying a put option and has a ceiling that is considerably above current new crop bids. However, these strategies are more complicated and it is important to understand how higher prices and margin requirements affect them.

-- Melvin

University of Missouri ExtensionDecisive Marketing - April 28, 2000 -- Revised: April 20, 2004