Todd's Take

Recently, I was looking at different choices for protecting price risk in new-crop corn and thought it would be a good idea to take a different kind of look at what December corn prices had done in the past. Going back to 1990, I used the Dec. 31 closing price as a starting point for each calendar year, then noted the high and low of each year, and the closing price on the final day of November, before December corn's delivery process began.

At best, I hoped to get a general sense of how far in percentage terms prices usually diverged from their starting point in any one year. I wondered if there would be a certain "uncle" point for hedging risk. For example, if the December corn price fell 10% from the first of the year, would that be a good time to cry "uncle" and hedge new-crop production?

What actually came out of the data was more interesting than I expected. First of all, the history of December corn prices showed a strong bearish bias, finishing the year lower in 17 of the 27 years with average losses of 4.4% per year. Thirteen of the 27 years -- nearly half -- saw drawdowns of 20% or more. The largest ending loss of the past 27 years was in 2013 when prices finished down 31%.

Based on that alone, we could just throw in the towel and say it's better to hedge new-crop production early in the year. But selling a futures contract can be risky to do before production is known, and an unexpected rally can lead to expensive margin calls. It seems better to start the year early with a relatively inexpensive put option.

Here is where the data got more interesting. As bearish as the track record is for December corn, it's not uncommon to get a decent rally at some point, often in the summer. Seventeen of the 27 years (63%) showed rallies of 10% or more from the year's starting price, yet only five of those years finished with a gain of 10% or more.

In short, corn rallies tend to be fleeting while drawdowns were often the anchor of how corn prices finished.

The challenge for producers dealing with this asymmetrical price behavior is to have a risk management plan that offers solid protection from falling prices without subjecting themselves to the shock of margin calls that unexpected rallies can create.

Once again, put options offer an effective solution without the pain of unexpected margin calls. The lesson of the past 27 years is that producers would be wise to take advantage of corn's upward price spikes by rolling their put options to a higher strike price before the rally disappears and takes away the pricing opportunity -- as it usually does.

One twist on buying puts that I would caution producers against is to also sell a call option, often advertised as a way of "paying for the put." As tempting as it sounds, I have seen too many instances where the call was sold, corn prices rallied higher, and then the producer had to take a big loss from being short a rising call option, not wanting to take on further margin calls. That is not risk management.

Here in 2017, December corn started the year at $3.80 and, so far, it has traded 6% higher with no drawdown yet. No one knows how prices will finish the year, but it is fair to say that history and Brazil's increasing corn crop estimates suggest plenty of bearish risk ahead. Market predictions can go sour, but I have yet to see a year where owning a relatively inexpensive put option was a bad idea.

Todd Hultman can be reached at todd.hultman@dtn.com

Follow Todd Hultman on Twitter @ToddHultman1

(AG/BAS)

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