Learning to use options as a tool
By Mike Rusch, Stewart-Peterson Inc.
As I mentioned in a recent article, feed prices, specifically corn, are at some of the most attractive levels we’ve seen. I also mentioned that now would be a great time to explore locking in some protection for feed, and that options would be a great way to do so.
For those of you who are not familiar with how options can work to protect a particular price for feed, here is a more detailed example.
How a call option for feed works: Let’s say we need to purchase 5,000 bushels of corn on April 1. Between now and then the price of corn, and therefore your cost, could be much higher. Since the April 1 price of corn is currently unknown, your risk is effectively unknown as well. A simple means of limiting and defining your risk is to buy a call option that will protect us from higher prices until the time we purchase our corn feed. Think of a call option as price insurance.
The components that make up an option are varied and can be somewhat complicated to understand at first. That said, the insurance analogy works great, in that “you get what you pay for.” The more "price coverage" you want, the higher the expense of an option will be. Time is the other dominant component. The more time you want, the more expensive the option is, and the less time needed, the cheaper the option becomes.
When selecting an option we’ll need to select a month that covers the time frame we need protected, but no more. In this case, we’ll choose May which expires near the end of April. Next we need to select the strike price, or how close we are to the current May futures price. The higher above the price we go the less expensive the options are, however, they provide less protection as well. Without going into strike selection details, let’s say we bought one May Corn $4.60 (the strike) Call Option for 15 cents per bushel. Since one corn futures option contract is 5,000 bushels, our total cost minus commissions is 750 dollars. With May futures currently trading at $4.42 per bushel let’s see what happens if price is much higher and much lower on April 1.
It’s now April 1 and May futures are trading at $6.00 per bushel. Without the call option our cost, not including local basis, is $6.00 per bushel. Our May call option is however worth at least $1.40 per bushel ($6.00 futures price - $4.60 strike price) and our net profit on the option is $1.25 ($1.40 value – our $0.15 cost) which we would realize by simply selling the option at the time we buy our corn. As a buyer of the option we have the ability to liquidate it (sell it) any time we desire before the expiration date. Since our $1.25 per bushel option profit can be put towards our $6.00 per bushel corn purchase, our net cost is $4.75 per bushel on April 1. In fact no matter how high corn goes, this will be our maximum cost! (Commissions and fees not included in this simple example.)
Okay, so what if corn goes lower instead? May futures are now $3.00 per bushel. Our call option is likely to be worthless at this point so our net cost will be $3.15 per bushel (our price plus the amount we spent on the call option). In fact we only add 15 cents per bushel to our cost regardless of how low the price of corn is on April 1. Keep in mind that this is the worst case scenario. You always have the right to liquidate the option before expiration, so you may be able to salvage value before it goes to zero.
In summary, our risk is defined as no greater than $4.75 per bushel no matter how high price goes all for a cost of 15 cents per bushel! Another way to look at it is we gave ourselves a chance to buy corn at a lower price, while not worrying about higher prices should that happen instead.
If you do not have much experience with price risk management tools, just know that you can learn slowly, with baby steps. It’s not necessary to go “all in” when you’re first learning about the markets. In fact, it isn’t advisable if you do not know what you are doing. As with all “power tools,” you should either be an expert or hire one. Either way, now is a good time to begin learning, before a feed price correction hits and you are learning in a high-price, high-pressure environment.
The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. This material has been prepared by a sales or trading employee or agent of Stewart-Peterson and is, or is in the nature of, promoting the use of marketing tools, including futures and options. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Stewart-Peterson. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results. Copyright 2013 Stewart-Peterson Inc. All rights reserved.