Managing 2012 price risk with options contracts

BLUE SPRINGS, Mo. — This year farmers have witnessed some of the most volatile futures prices in history. However, there are tools farmers can use to reduce the risk from commodity price fluctuations, says a University of Missouri Extension agriculture business specialist.

“One such tool is the option contract,” says Whitney Wiegel.

An option on a commodity futures contract is the right, but not the obligation, to buy—a “call” option—or sell—a “put” option—an underlying futures contract at a specified price, called the strike price, Wiegel said.

The cost of the option, called the option premium, varies according to the strike price, the current value of the underlying futures contract and the amount of time until the option expires.

“The beauty of buying options as part of a marketing plan is that the farmer buying the option knows at the outset how much he stands to lose by purchasing the option,” he said.

The most the option buyer can lose on a put or call is the option premium. “Because an option does not obligate the buyer to exercise his right to buy or sell the underlying futures contract, the owner can only lose what he paid to obtain the option,” he said. “However, if the price for the underlying futures contract changes such that exercising the option would be profitable for the farmer, he can exercise the option or sell it to improve his financial position.”

Wiegel offers an example to illustrate how a put option can fit into a marketing plan:

John grows corn and wants to reduce the risk that the price he receives for his corn will go down. It is late summer and the local cash contract price for fall delivery is $8 per bushel.

“Because John isn’t sure if the cash price will be higher in the fall, when he plans to sell his 2012 crop, he does not want to forward contract, but he does want some price insurance,” Wiegel said. So John decides to purchase put options on the December futures contract. He chooses a strike price of $8 on the December contract and pays a premium of 50 cents per bushel for the put options.

“This provides John some price support by giving him the option to sell December futures contracts at $8 per bushel,” Wiegel said. While it costs John 50 cents to obtain the right to sell December futures at $8, John has achieved his marketing goal of establishing some price assurance. “Using options, John has locked in a futures price floor of $7.50—the $8 strike price minus the 50 cent option premium.”

If futures and cash prices go down between the time when John bought his put options and the contract expiration, he can either exercise his put options and sell December futures contracts at $8 or he can sell his options to someone else. If futures and cash prices go up, John can either hold his options until they expire or he can try to recapture some of the premium he paid by selling his options before expiration.

To learn more about how options can fit into a farm marketing plan, see the MU Extension publication “Introduction to Hedging Agricultural Commodities With Options” (G603), available online and as a PDF download at www.extension.missouri.edu/G603. There you will also find links to related publications that explain futures and options contracts in greater depth.