Put works when futures markets recover and base widens, analyst says
A put option is a risk management instrument traded on an exchange.
The buyer of a put option has the right but not the obligation to sell futures contracts. A put option can be viewed as a tool to establish a floor price in a market, while allowing the spot commodity to participate in a price increase. With this in mind, we will take the approach of using a put option if you are a corn farmer.
Each year, a corn farmer will plant that many acres and estimate total production based on a historical yield. As market opportunities arise, many will attempt to shift the risk ahead of the harvest.
Typically, but not always, prices are higher in the winter and spring than they are in the fall, when the crop supplies the market. Risk transfer can be effected using forward contracts, hedges or other instruments.
If a farmer chooses to buy a put option, he usually sets a floor price on the bushels he does not intend to sell before harvest. Therefore, in a year like this where prices have risen sharply, the idea of establishing a price floor makes sense. Unlike a futures contract, a producer is not obligated to deliver when purchasing a put. Many farmers use a combination of futures and put options. The put options are also flexible. When you own a put, you can sell it at any time. Or, if you want, you can exercise it and convert to short futures.
The argument for using put options this year is that prices have rallied dramatically as supply has declined. In addition, there is always a risk in producing a crop regardless of the growing season, as weather is the most important factor affecting production. Therefore, in a year of tight supply, if less than ideal weather conditions develop, prices could increase significantly. By buying a put, a farmer could put a floor in the market and participate in the rally, setting the grain price for cash later.
Another reason to use a put option is that, usually during a strong rally in futures contracts, the base widens. Therefore, futures contracts may not be an attractive alternative. On the other hand, if there is a solid foundation, a farmer may have an interest in entering into futures contracts. Yet there remains the dilemma of how much to sell forward.
Current new crop corn futures are trading near $ 5.50 on the Chicago Board of Trade’s December contract. It doesn’t take a vivid imagination to imagine prices reduced to $ 4.00 in good weather. On the other hand, the weather could push prices to new all-time highs above $ 8.00. Buying a put is a good alternative in a potentially volatile market.
When buying a put, determine the level of protection you want. This is called a strike price. You also want to purchase the appropriate schedule. Typically, put options are bought against the December corn futures contracts as they provide protection during the harvest season. The cost of a put option is called a premium. In volatile markets, the premium is more expensive than when prices are trading sideways or at low volatility. Duration is also a fixed price. The more time you buy, the more expensive an option will be.
There are a lot of considerations when it comes to marketing. Make sure you look at all of the marketing tools and have a working knowledge of their potential benefits and risks. Work with an impartial person who will help you achieve your goals and who can implement the right strategy for you.
Keep in mind that nothing is free. Options cost money, but they are often money well spent in creating and crafting a marketing strategy to shift risks and take advantage of opportunities. Find a lender who has a working knowledge of marketing tools and is willing to work with you. 2021 promises to be volatile. Finding the right tool at the right time for the right reason is part of a strong marketing strategy.
Futures trading is not for everyone. The risk of loss in trading is high. Therefore, carefully consider whether this type of trading is right for you in light of your financial situation. A previous performance is not necessarily indicative of future results.