Put Options Would Have Made This Farmer Thousands of Dollars October 2021
This could happen to you if you don’t begin utilizing this simple risk management tool.
A prospective client contacted me last month. Let’s call him Paul. He wrote:
Due to drought in 2020 I had to carry over 10,000 bu. of cash corn delivery contracts to 2021. The price was at $2.91 per bushel cash contract. I know the elevator did a hedge for my contracts and are probably out $2.00 or more on my $2.91 cash contract. I know there is no legal recourse and the elevator did nothing wrong. At this point I can only ask if there is anything I can do to get more money with these contracts?
Further communication revealed that back in the first half of 2020, when corn prices were in sharp decline and May corn matched a 14-year low at $3.01 on April 21st, Paul expected corn to continue lower to $2 per bu., so he contracted a bunch of bushels. Dry weather hurt his 2020 production and Paul was 10,000 bushels short on his delivery obligation. His merchandiser agreed to roll 10,000 bushels to a 2021 crop delivery.
Now that December 2021 corn is about $5.50 a bushel, the elevator has about $2.60 a bushel tied-up in margin money for Paul’s hedge and, understandably, the merchandiser wants to recoup that money. There are only two ways that can be done:
· Paul delivers the corn, gets paid $2.91 and the merchandiser sells the corn for $5.50 or so.
· The merchandiser liquidates the hedge position and Paul writes a check to cover the hedge loss.
How to avoid this in future
How could this situation have been prevented and, yet, still give the farmer price protection against corn going to $2.00?
First of all, this is exactly why many farmers will not price anything until the grain is in the bin.
Yet, that is simply not possible for most farmers.
A much more practical solution is to buy the right to sell the commodity at a specific price without the obligation to deliver at that price. Most farmers do not know the marketing tool to do just that, but it has been available for the past 38 years.
In this situation, had Paul bought a $3.20 December 2020 corn put instead of forward contracting his corn, he would have had the $2.90 floor price for an investment of about 30 cents. That investment would have given Paul the right to sell corn at $2.90, which is what he wanted, but he would not have had the obligation to deliver corn at $2.90.
As market action turned out, had he bought the put, Paul would have lost his 30 cents he spent to buy the put option, but he would be able to sell his 2021 corn today at $5.30 or so with a minus 20 basis. After the cost of the price insurance (put option) is deducted, his net would still be $5.00 with a lot less stress.
Probably Paul’s merchandiser would have bought the put options for him in the spring of 2020 in exchange for Paul’s contractual obligation to deliver the corn.
Paul could have bought the put options in his own futures and options account; the put options would have expired worthless last fall because December 2020 corn was above his guaranteed selling price and that would have been the end of this marketing story.
This fall there are hundreds, maybe thousands, of Canadian farmers facing the same dilemma on grain and canola contracts. The Canadian farmers cannot deliver the crops because they did not raise the crops and the farmers cannot write a check for the loss because they have little to no crop income.
All of that misery and great stress could have been avoided if put options had been bought to lock-in a floor price.
With puts, farmers can lock-in a floor price on every bushel they expect to produce. If they don’t grow it, no harm, no foul.
Puts appear expensive at the time of purchase, but when the futures price goes down, they are a good investment. When the futures prices go up, you get to sell at the higher price. The only time puts don’t do a farmer any good is when the futures price trades sideways for a long period of time. How often does that happen?
When will we, as grain marketers, learn to use puts?