Market Matters Blog

How Expensive Are Options, Really?

Options are expensive, and farmers don't like writing a check for something that will expire worthless most of the time. Yet market advisers say farmers need to break this mentality and start thinking of options as insurance.

A lot of farmers look at options and "expect to make money on that option. That's a bad way of looking at it," argues Iowa State Ag Economist Chad Hart. "When an option expires worthless, that means the market has given me a better price than I feared could happen. I talk about using options to protect myself against bad events, not strictly as an income measure."

Farmers are being asked to think about their crop insurance as a "put," and their put as insurance. The difference is that revenue protection policies cover yield in addition to price. Both options and insurance protect a farmer when prices fall out of bed, while leaving the upside open. They're different, and they're the same.

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The cost difference between the two clearly favors crop insurance, as you know. Since insurance can't cover all of an average crop, options are a good tool for the remaining 15%, or however much a farmer didn't cover with his insurance. The current DTN 360 Poll shows that 28% of the current respondents plan on buying higher levels of coverage this year. That's probably a good thing, as Marcia Taylor pointed out earlier this week: crop insurance could pay out this year if prices get low enough. There doesn't even have to be a yield problem.

So for price protection this year, crop insurance is a good bang for your buck. A simple example: a Daviess County, Ind., farmer with an actual production history of 165 bpa who buys an 80% RP policy will pay $40.11 per acre, or 24 cents per bushel. A $5.50 December put cost about 45 cents.

In this week's series, Consider the Options, I wanted to get my readers thinking about what's going on in the markets and the tools that'll work well in this environment. The risk of $4 corn -- or even $3 -- is very real if the weather cooperates. On the flip side, a weather disruption could launch prices to new highs.

There's profit in the new-crop market today for a lot of producers, Hart said. Standard options are just one way to lock it in. Farmers may want to discuss short-dated new crop options with their advisers this year, especially if they despise writing a check for the premium.

So, how expensive are options, really? The answer isn't as simple as dollars and cents. Everyone has a different appetite for risk, different farm financials, and different production potential. If you view options as supplementary price insurance, maybe that check isn't too big for you to write. But if you're not willing to part with some working capital, and possibly lose it forever, options will always look pricy.


Editor's Note:

As with any discussion of marketing strategies, it's important to note that producers have to evaluate the information in terms of their own situations. Commodity trading is complicated, and the risk of loss is substantial. The information here is general, and is NOT a substitute for a producer's independent business judgment or the advice of a registered commodity trading adviser.

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Comments

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Brent Heid
3/19/2013 | 1:14 PM CDT
Katie, I have an options position "on" almost continuously for various crops and purposes. I will say, though, that I expect to make a little money on them in the long run. To accept options as a continual expense with no return is to accept purchasing something that you did not need or lack the expertise to execute profitably.
Brandon Butler
3/15/2013 | 12:04 PM CDT
You make some excellent points, with very good logic, logic which unfortunately is lost on more producers than should be. A statement that I've made and tried to taylor my thinking to is that I hope a hedge never works out. While there are some exceptions to this, in general what that means is that suppose I sell/hedge this falls grain for 5.50. If by the time we get to that and the market is higher, that means more than likely I'll be able to sell the amount I haven't sold already for more, in addition to future crops for higher prices. I swear that there is a mentality out there that is such that the producer would rather sell a portion of their crop at the high, and even though it goes down from there and the amount still in their bins is dropping in value, they still sold the high, or (God forbid) they sold ANY crop for less than they could have. I think that for the most part DTN (their are a few analysts/bloggers on here, as anywhere that are doing their readers a dis-service) is doing a good job illustrating to producers that they need to protect the up as well as the down, i.e. options. Probably the most important part (a lesson learned the hard way) of your operation to protect is your INCOME. If you look at it that way, that should help make the decision.
MICHAEL T HORA
3/15/2013 | 9:28 AM CDT
Katie, your option marketing series are excellent and informative. Thankyou!