Since the projected crop insurance price was established at the end of February, a substantial price gap ($1.51 ¾ per bushel as of May 18th) has opened between the current December futures contract price and the projected crop insurance price (Figure 1). The futures rally has been fueled by numerous factors – Ukraine-Russia, drought concerns in the U.S., lower planted acreage in the U.S., high input prices, strong global demand, and reduced global stocks. The strong upward trend in price has made producers hesitant to make sales or hedge price risk. Many producers have been reluctant to cash forward contract a large portion of their 2022 corn due to fears of missing out on higher prices and production concerns in drought affected regions in the South. Additionally, producers that traditionally use futures to hedge price risk are concerned with the potential for large margin calls if prices continue to appreciate.
Figure 1. December Corn Futures Contract Daily Close and the Projected Crop Insurance Price, January 3, 2022, to May 18, 2022.
A marketing tool worth considering is options. Options strategies can be made as complex or simple as the market participant desires. This article illustrates two examples. Alternative #1 is more complex, and Alternative #2 more basic. For the two strategies, the goal is to manage downside price risk on 15,000 bushels (three 5,000-bushel contracts) while allowing upside mobility in the futures price. We do not include basis in the analysis and all prices and premiums are as of May 18 for the December 2022 corn futures contract. Results shown are at option expiration when time value in the premium goes to zero.
The two alternatives examined are:
Sell one $7.50 put option for a premium of $0.75;
Sell one $7.50 call option for a premium of $0.75; and
Buy three $7.10 put options for $0.50.
The strategy results in a net zero premium to the producer (excluding transaction costs). Alternative #1 is subject to maintaining margin in a futures and options trading account.
Buy three $7.10 put options for $0.50.
The strategy costs the producer $0.50 per bushel up front (plus transaction costs), but no margin account is required.
Figure 2 depicts the outcome for both alternatives if December corn futures trade between $4.00 and $10.00. If the red dotted line (Alternative #2) is above the black line (Alternative #1), then Alternative #2 has a preferable outcome to Alternative #1, and vice versa. Based on the analysis there are two key December corn futures prices when the preference between the two alternatives switch – $6.00 and $9.00. Simply stated, if the December corn futures contract price is between $6.00 and $9.00, Alternative #1 yields a greater outcome than Alternative #2.
Figure 2. Outcomes for two options strategies at December corn futures contract prices between $4.00 and $10.00.
Both strategies can help manage price risk for corn producers. Alternative #2 sets a futures price floor at $6.60 ($0.70 above the projected crop insurance price) and allows the producer to participate if the December futures contract continues to strengthen. Additionally, the put options could be resold, and a portion of the time value recovered, prior to expiration if December corn futures prices remain high. Alternative #1 provides greater outcomes when the December corn futures contract is between $6.00 and $9.00; however, it does not set a futures price floor and comes with margin requirements.
The two alternatives described above are examples of how options can be utilized to reduce price risk in futures markets. For those producers new to trading futures and options, it is strongly recommended to work with a qualified broker or professional when examining potential strategies and outcomes.
Disclaimer: Comments are for educational purposes and are not meant as specific trading recommendations. The buying and selling of corn options involve risks and are not suitable for everyone. Working with a qualified broker or grain merchandiser is strongly suggested.
References and Resources:
USDA – Risk Management Agency. Price Discovery Tool. Accessed at: https://prodwebnlb.rma.usda.gov/apps/PriceDiscovery/GetPrices/YourPrice
Barchart.com. Corn soybean and wheat historical futures prices. Accessed at: https://www.barchart.com/futures/grains?viewName=main
Smith, Aaron. “Managing the Price Risk Gap between December Corn Futures and Projected Crop Insurance Prices“. Southern Ag Today 2(23.1). May 30, 2022. Permalink