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Risk Management Toolbox: A Primer on Hedging with Options

By: Scott Stewart

Which way will commodity prices go in 2013? The conventional wisdom has been that prices will go up, up, up. Weather will be a primary driver. If the country gets enough moisture, prices could just as easily fall in dramatic fashion.

To venture into this uncertainty with a forward contract or a futures contract is stressful. Therefore, many farmers are using options. In fact, there are more reasons to use options in 2013 than in all of my 30 years’ experience because of the flexibility they offer.

Hedge lines of credit enable the marketing function for many of today’s livestock and dairy operations, and some grain operations, too. Here is a primer for the lender who wants to support and have a basic understanding of the farm clients’ use of options.

Puts and Calls

There are two basic types of options — a put option and a call option. For the purposes of this article, let’s talk about put options. Put options give the farmer the opportunity to set a floor for the sale of the commodity without creating a ceiling. That is appealing in a bullish environment.

Buying a put option gives a farmer the right (but not the obligation) to buy or sell a futures contract at a certain price (called the strike price). That right comes with a cost — a premium. It is like renting a piece of equipment with an option to buy. You pay a premium to retain that right, should you choose to own that equipment in the future.

When a farmer hedges using futures contracts, the results are two dimensional — there is either a gain in futures or a loss in cash, or gain in cash and a loss in futures. With options, however, your results depend on multiple, ongoing decisions. That is why options have to be well-managed. They are multi-dimensional.

Options have a value of their own, and are actually bought and sold in the marketplace based on that value. The value of options fluctuates based on several factors:

The intrinsic value of an option is what it is worth in relation to its underlying futures contract. The intrinsic value changes whenever the futures market changes. Here is the basic equation:

Put option intrinsic value = strike price – current price of the underlying futures

Time value is an amount over and above the intrinsic value of an option. Remember, options are bought and sold by traders who are evaluating the risks and rewards of holding them. Time is valuable because it represents the chances that the option will actually get used — or not used. Generally, the time value of an option drops as it nears the expiration date. That is because, simply speaking, there is less chance the option will have value in it, so the option costs less in the marketplace.

With respect to time value, you can view options much like auto insurance. When purchasing insurance, you are buying protection for a specified amount of time. Six months of coverage is cheaper than nine months. With options, fewer days of protection will cost less.

Here are some other key concepts regarding the time value of a put option:

An “at-the-money” option is a contract with a strike price that equals the current futures price. That means it has no intrinsic value. The premium for an at-the-money option is entirely time value. It basically is used to protect against falling prices. 

An “in-the-money” option is a contract that has a positive intrinsic value. It is a put with a strike price above the current price of the underlying futures. It provides a price floor higher than the current futures price. It is usually more expensive than an at-the-money put because it has both intrinsic and time value.

An “out-of-the-money” option is a contract that has no intrinsic value. It is a put with a strike price below the current price of the underlying futures. It is less expensive than an at-the-money or in-the-money put option and yet provides a price floor against falling prices. The level of protection is less than using an at-the-money or in-the-money put option.  

When the option reaches its expiration date, the put will be worthless or have only intrinsic value. All of the time value is now gone. Good hedgers understand the time value erosion curve of the options they own. Owning options is like owning another commodity, the value of which has to be managed.

Using Options in 2013

In volatile times, premiums for options go up because there is more risk that they will retain their value. It will take a great deal of skill to keep option costs down during volatile markets.

If a bank’s clients are using options, the hedge line of credit will need to be ample enough to support the marketing program. The best farm operations maintain good communication between the farm owner, the market adviser and the banker so that the hedge line of credit is set at the appropriate level and marketing decisions can be made objectively, not based on cash flow.

A point of caution when it comes to keeping costs down: Some producers will be tempted to “ladder” options when the market is rallying, repeatedly raising their floor price. The producer might tell you that he is actively managing his positions, and the activity seems impressive. On average, that producer may be spending a lot of money laddering all the way up the market, and will be lucky if that last put option captures enough value to cover what was already spent on the way up.
 
Options are simple tools on the surface, with much complexity underneath. Knowing how to use them independently or in combination with other tools can help producers cost-effectively manage all the risks and opportunities an uncertain environment provides.

Scott Stewart is CEO of Stewart-Peterson Inc., Great Bend, Wis. Contact him at
scotts(at)stewart-peterson.com or 800-334-9779.

Copyright (c) March 2013 by BankNews Media



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