Options -- Market Tools for Uncertainty

This year’s grain price situation creates a real marketing and management dilemma. Failure to take advantage of any spring price strength could result in low returns or "red ink" if prices plunge again in the fall. But the possibility of selling early and then watch prices surge upward in the summer, due to dry weather which also reduces production prospects, isn’t a pleasant situation to be in either.

Dealing with this uncertain price and production situation will require using more than one marketing tool. The market loan program does provide price support at loan levels, reducing some of the downside price risk. Multi-peril crop or revenue coverage insurance can also provide some production and revenue insurance. But these probably aren’t enough. Profit potential still depends upon taking advantage of sales opportunities. Options may provide the "price insurance" necessary to make pre-harvest selling decisions easier.

A call option can be used as "insurance against missing out on higher prices." Buying a call option acquires the right to purchase a futures contract at a specified price (strike price). It provides insurance in this manner. Suppose prices rally above loan rate in the early spring to prices that, while not great, appear to be better than what is expected in the fall. At least a portion of the crop could be forward contracted at these prices. Then, if summer weather turned poor and prices soared, the call option could be exercised or liquidated at the higher prices. This would capture the price gain that the spring forward contract had missed. This gain could be added to the contracted prices resulting in a much higher net price. If no summer weather problems occur and prices fall, the call option expires worthless and the spring forward contract will have been a good sale. Buying the call option makes it easier to make those early sales on spring rallies, knowing that it will provide "insurance" against missing out on any big summer rally.

A put option can be used as "insurance against lower prices." Suppose, instead of buying a call and forward contracting on a spring price rally, a put option is purchased. This gives the right to sell futures at a specified strike price and establishes a minimum price that can be hedged if prices decline. If harvest prices are lower, the put option can be exercised or liquidated and the gain added to the lower cash price received -- resulting in a higher net price at or near the protected minimum price. If weather problems occur and prices go higher, the put would expire worthless and the grain could still be contracted or sold at the higher cash market price. This strategy allows delaying cash sales, while still "insuring" against lower prices.

The advantages of buying options are that no obligations to price or deliver are made. This allows for pricing flexibility without the worry of production problems and commitments for delivery quantities. The disadvantage is the option premium (cost of the option). These premiums can become more expensive if weather uncertainty adds risk to the markets. In spite of the premium cost, using options can compliment other marketing tools and provide the flexibility needed to help deal with this year’s price and production uncertainty.-- Melvin

Decisive Marketing - March 5, 1999
http://outreach.missouri.edu/agconnection/DCT/DM990305.html -- Revised: April 20, 2004
breesm@missouri.edu