While the 2022 harvest season is not complete, it is a good time for producers to consider price risk management strategies for the 2023 crop. Agricultural commodities have a tremendous amount of uncertainty due to global and U.S. economic weakness, elevated input prices, weather, competition from South America, exchange rates, interest rates, and inflation. With uncertainty comes greater price volatility, which is expected to continue in 2023. Additionally, many producers will be making input purchase decisions before the year’s end. With high input prices continuing into 2023, producers should consider establishing a price (or price range) for their crop when inputs are purchased. High input costs and uncertain commodity prices necessitate producers prioritizing price risk management.
Figure 1. Example of two December corn options fence strategies that are premium neutral
For producers wanting to establish a price range in the futures market, consideration should be afforded to options fence strategies. In other words, how much upside potential are you willing to sacrifice to secure a minimum price? An options fence sets a minimum futures price and maximum futures price. To execute an options fence, a producer buys a put option with a strike price below the targeted futures price, sells a call option with a strike price above the targeted futures price, and maintains the option positions until the cash commodity is sold. For example, consider the following two option fence strategies (for reference, on October 20, December 2023 corn was trading at $6.24):
Strategy #1: A producer buys a $5.60 put option for $0.30 and sells a $7.20 call option for $0.30 (Figure 1). The producer has “fenced” in a price between $5.60 and $7.20 using options in the futures market, or simply stated the producer will not receive a futures market price below $5.30 or above $7.20, assuming execution of the options contracts and sale of the cash commodity.
Strategy #2: A producer buys a $6.00 put option for $0.50, sells a $6.50 call option for $0.50 (Figure 1). The producer has “fenced” in a price between $6.00 and $6.50 using options in the futures market, or simply stated will not receive a futures market price below $6.00 or above $6.50, assuming execution of the options contract and sale of the cash commodity.
Similar to a short hedge, when using an option fence, it is imperative to have offsetting transactions in the cash market. If the December futures market price is above the call option, strike price money is made in the cash market at the same rate as the losses in the futures market (without accounting for basis). Similarly, if the December futures contract is below the put option strike price, losses in the cash market are offset by gains in the put option position. Thus, the net return to the producer remains between the put option strike price and the call option strike price (assuming no changes in basis).
Option fences can be set in a narrow (Strategy #2) or expanded range (Strategy #1), depending on the producer’s risk tolerance and the strike prices selected. An options fence is one of many strategies that can assist producers in managing their price risk. Obtaining professional advice to weigh risks and rewards when utilizing futures or options strategies is strongly recommended.
Important considerations:
- Fences do not need to be premium neutral.
- Selling options require margin, so liquidity or access to credit is essential.
- Options strategies do not protect against basis movements, this can be a positive or negative depending on your location and production season.
- Premium neutral strategies carry transaction fees and finance charges.
- Formulating reasonable price expectations are key.
- Fences do not protect against production risk and require an offsetting transaction in the cash market.
Resources and ReferencesBarchart.com. December 2023 Corn Options Prices. Accessed at: https://www.barchart.com/futures/quotes/ZCZ23/options?moneyness=20
