Smart Use of Options in a Marketing Plan

The Smart Use of Options in a Marketing Plan

Trading options as a business management tool has at-times been given a bad rap at the coffee shop. Let’s take a look at the world of options and their ability to pass off price risk, while guarding producer profits . . . .

There’s still so much caution toward the use of options, partly because of terminology, partly because they seem like expensive insurance. But is this risk management tool truly too complicated and expensive or simply under-utilized by commodity producers? Let’s get started . . . .

Purchasing ‘put options’ guard production profits. Simply, put options act as price insurance policies for falling prices.

These ‘puts’ place a futures price floor without under production or delivery obligation. And if your insurance doesn’t kick in, that may mean that commodity prices or let’s say grain in the bin (in this example) is doing just fine price-wise. But sometimes, you really need that price protection, especially should cash prices swoon. In fact, it may be your only lifeboat toward profitability during bearish market cycles.

Canola options are traded actively through the ICE exchange. Corn options are used commonly by Cdn growers and livestock producers to manage Cdn feed price risk and expectations. The beauty of corn is; it is a very liquid contract that can be traded more than one (1) year forward using futures contracts.

Purchasing options (calls or puts) is generally done for six (6) months or less. Why? Time value places an extra premium on option values.

Remember, put options guard a price floor while the crop is growing or in unpriced storage or cattle are on feed (as an example).

Put options increase in-value as futures contract prices drop. Call options are just the opposite. Call options increase in-value as the futures head higher.

As a business management tool, call options can reopen your price ceiling after the cash commodity has been priced (contracted). This is more price speculation than price risk management. But then your risk is now limited to the price of the call option only, not your entire physical production. A big plus . . . . Let’s look at grain again.

Replacing physical grain sales with call options may be a less risky strategy than owning unpriced grain in the bin that has the added risk of going out-of-condition. Remember, if market prices drop, there is more financial risk watching the value of unpriced grain drop than watching a call option premium expire worthless.

Like all things, this pricing tool has to managed. Without care, options won’t be as effective. And there are key factors that can greatly enhance your success with options when managing your commodity price risk. Here are some key factors that can impact the success options will have on a business marketing plan . . . .

Buy quality, not quantity. One mistake many producers make is purchasing inexpensive, out-of-the-money options. Here’s an example.

Let’s say May canola is trading at $660/MT. You have been storing unpriced canola, but you’re leery that canola may break down further into the early spring market. May canola (at-the-money) 660/MT put options are trading $35/MT. But you decide to buy May (less expensive) $600/MT put options for $15/MT.

Let’s say, May canola breaks down to $600/MT late winter. The May $600 put premiums would only appreciate by about $10/MT to $25MT. But the May $660 put premium may now be worth $80/MT ($60/MT in-the-money plus time value).

If you have a set amount of money to purchase options, it is often better to cut your order down, but purchase better quality options. Realize this is a Cole’s notes explanation, but the jest is there . . .

Be wary of time decay. In the last month of an options life, the premium can erode quickly due to ‘time decay’. Rule of thumb; don’t hold options until expiry. If you own a May canola $660 put and the market slides quickly to $600/MT, your option premium value is made up of the $60/MT you are in-the-money ($660 - $600 plus time value). Your option premium may actually be worth $80MT. The extra $20/MT is ‘time value’. As the option nears expiry on the 3^rd Friday of April, the time value will eventually erode to $0.

If you own an option, try to sell or liquidate it 2 to 3 weeks prior to expiry. This will help ensure that you will capture the time value left rather than allowing it to expire.

Options for corn, soybeans, soyoil, soymeal and Kansas City wheat are used commonly across western Canada. These contracts offer great liquidity. And this allows growers the ability to enter and exit trades easily.

Minneapolis spring wheat (MWE) options are less liquid, but they can offer solid price protection for Canadian spring wheat growers.

For oilseed production, canola and soyoil options are both effective tools to manage price risk. Canola options trade in 20MT increments. For soyoil, one 60,000 lb contract is nearly the equivalent of one 3,000 bushel railcar of canola.

Corn options can be an effective replacement for barley and feed wheat sales. And from a feeder’s viewpoint, corn is about 10% hotter in energy than barley in rations. And soymeal options are an effective replacement for feed pea sales. Hog producers often use soymeal options in their price risk management plan.

And another strategy is; you can also use options to replace poorer-quality grain. Option contracts are always based on the top grade futures specifications. By selling your off-grade grain and replacing with higher quality options, you are effectively pushing your grades into a higher value marketplace.

You can use options as a price parachute for your unpriced commodity exposure.  From cattle to steel to lumber to copper (the list goes on), the use of options can manage price risk. Plus the producer has no physical delivery obligation and there is NO RISK OF MARGIN CALL.

Remember, as a buyer of options, your risk is limited to the cost of the premium. But a ‘big plus’ incorporating options into a business management plan is; it allows commodity producers to remain disciplined in their market planning through periods of high volatility.

Both puts and calls can be utilized in a business risk management plan. It’s all about risk management and guarding those production profits.

Using options are a smart and solid management tool. They simply allow added flexibility in a marketing plan. And the use of options can inject cashflow more quickly into a business.

If traded effectively, options can guard market downside for unpriced commodities or reopen a price ceiling after the commodity has been sold. It is just another tool to add to your marketing toolbox and ignore that coffee shop talk . . . .

Next up . . . Podcast time. Let’s talk about China’s economic depression and the impact on the commodity world.

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