Put Options Lesson 17: Price Enhance

This is a continuation of articles about the use of put options on commodity futures as a primary marketing tool to lock-in a minimum price or as a price “enhancer” of forward contracts or HTA contracts.

Here in August, we have been discussing the process to maximize the income from the sale of a previously purchased put option. Since put options increase in value as the futures price declines, the first objective to maximize put income is to sell the put when the underlying futures contract price is as low as possible. That is much easier than picking the top. Prices usually spend one to three months near the low, but only one to three days near the top. September wheat traded above $12.50 three days in May. The high was $12.85 on May 17^th.

You can see on the chart below that September wheat traded below $7.75 fourteen days beginning July 11^th. It traded below $7.60 four days spread over four weeks and three days below $7.50. The sideways trading pattern, the seasonal low is in August to early September and multiple technical factors indicated during August the low for the year was probably in place, picking a place to sell the puts for near maximum value was not difficult. Many of our clients sold the September puts when the futures price was in the $7.36 range, so they missed the ten-month low by 11 cents.

Let’s see how the four mythical farmers who used different market plans fared. We will pretend they all sold their options when September wheat was $7.36 as did several of our clients.

Dan had contracted wheat at $11.00 on a HTA and bought the $9 and $10 puts for 29 cents per bushel for each HTA bushel. The $9 put was sold for $1.65 per bushel and the $10 put was sold for $2.65. His net profit on the puts was $18,600 (1.65 -.29 = $1.36; times 5,000 bu) + ($2.65 -.29 =$2.36; times 5,000 bu). For each HTA bushel, Dan added $3.72 of put profit to his $11.00 HTA for a net HTA price of $14.72. Not bad for selling his wheat $1.85 below the contract high of $12.85.

Joe contracted wheat at $11.00 on a HTA and bought the $10 and $11 puts for 59 cents each.

He risked more money on the puts than Dan risked, but he made more money on the puts.

He sold the $10 put for $2.65 and the $11 put for $3.65. His put profit was $25,600 or $5.12 per HTA bushel. His net HTA price was $16.12.

Don, who did not sell the futures, but bought a $9 put for 29 cents and then, when the futures gained a dollar, he bought a $10 put for 29 cents, just as Dan did. His net put profit was $3.72 per bushel was added to whatever his cash price was. If he sold the wheat off the combine the first half of July, futures were between $8 and $9. Let’s say $8.50+/- the basis. Add $3.72 put profit to $8.50 and his net cash price was $12.22 +/- basis. The worst thing that could have happened to Don would have been if wheat stayed in the $10 to $11 range. He would have probably broke even on his puts and netted $10 to $11, which is not all bad. If wheat had gone to $20, his two puts would have expired worthless. The cost of the two puts (58 cents) comes off his $20 wheat, so his net would have been $19.42+/- basis. Of course, he would be happy his puts expired worthless. The other extreme would have been if September wheat went to $4.75 like it did in 2020. His net on the two puts would have been another $5.20 a bushel.

Junior, who did not sell futures, but bought the $10 put for 59 cents and then bought the $11 put for 59 cents. If sold his wheat off the combine like Don did, he netted $13.62 +/- the basis.

Dan and Joe used the HTA as their primary marketing tool and the puts as a price enhancer. Don and Junior used the put options as the primary marketing tool.

We love the length of time available to select a futures price reasonably close to the low to sell the puts.