Rolling Put Options Protects Minimum Price

By CnAgri2012-09-06 01:31:37 Print

For the last couple of months, many marketing advisors have advocated the use of put options to establish a minimum selling price for corn and soybeans, says Darrell Mark, Ph.D., Adjunct Professor of Economics at South Dakota State University.

"This marketing strategy has advantages and disadvantages, but one of the most appealing advantages is that it protects a minimum selling price while allowing the hedger to benefit from price increases," Mark said during a recent iGrow Radio Network interview.

He says one of the strategies now being discussed by marketing advisors and considered by producers in light of the continued price rally is whether to "roll" these put options to a higher strike price.

"Rolling to a higher strike price creates higher minimum sale price. The mechanics of the roll are accomplished by offsetting, or selling, the put option that was originally purchased and buying a put option in the same month with a higher strike price," Mark said.

He shares an example to explain how this works:

Suppose that on July 20, 2012, a corn producer decided to purchase a $7.00/bu December 2012 corn put option, thinking that the corn market was reaching a high. At that time, the cost, or premium, for that put option would have been $0.30/bu. If the commission costs for trading this option totaled $0.02/bu and the producer expected the basis to be -$0.40/bu, then the minimum expected sale price (MESP) would be $6.28/bu.

If December futures prices trade below $7/bu, then the put option gains intrinsic value and offsets the lower cash market price for the corn (although basis risk is still present).

If December corn futures go higher, then the put premium declines but the cash grain is sold for a higher price, but the most money that could be lost by owning the put would be the total premium paid. It would be possible for the option to be worth a small amount sometime before the put expires; however, if December futures are above $7/bu when the option expires, the option premium would be virtually worthless if held until expiration.

While the producer might have thought that December corn futures were setting a high back on July 20 and decided to initiate this put option hedge and establish a MESP of $6.28/bu, it turns out that crop conditions worsened and the corn market has went up about $0.20/bu through the third week of August. Even though the put option is worth much less now, this isn't necessarily a bad thing for the producer. In this case, the cash corn can be sold for a higher price and, assuming that the producer didn't hedge 100% of production, a higher overall price is realized for the crop.

"Basically, it is somewhat like having auto or life insurance and not using it," Mark said.

Another way though that the producer could take advantage of the price increase would be to roll the option up to a higher strike price and increase the MESP. By August 23, the $7/bu December 2012 put option was trading for about $0.10/bu, meaning that the put that is currently being held could be sold back for $0.10/bu. This would mean that this put option trade would have lost $0.20/bu, plus commission. However, the $0.10/bu is being recaptured (of the original $0.30/bu premium) and can be put towards the purchase of another put with a higher strike price. In fact, the $8/bu December 2012 corn put option was trading for about $0.40/bu on August 23. If the option position was rolled from the $7/bu strike price to the $8/bu strike price on August 23, the MESP would increase to 6.96/bu.

Now, the producer has a floor selling price of nearly $7/bu for a total net premium cost of $0.60 and $0.04/bu commission. Before rolling, the floor price was $6.28/bu at a total cost of $0.32/bu.

Is it worth it?

"It depends on the producer's risk tolerance and market outlook," Mark said. "For a producer with a relatively bearish outlook on the corn market price during harvest this year and who is quite risk averse, this might be a good strategy to consider. For a bullish producer that is willing to have price protection that is deep out-of-the-money, doing so might not be necessary. Either producer, though, should consider what his/her goals really are for marketing. If the put option hedge was originally designed to protect a floor price that would insure a profitable price (above breakeven), then rolling to a higher strike price is only adding to hedged profit - which is always nice, but may not be necessary for some producers given the cost," Mark said.

He explains that should the market continue higher, the option could be rolled higher yet again by offsetting the owned put and purchasing one with a higher strike price.

"The only time you wouldn't want to do this is when the underlying futures price does not increase more than the net option premiums and added commission. Doing so would result in additional trading expenses without increasing the MESP," he said.