Mecardo Analysis - Protect your price through a put
- By: "Farm Tender" News
- Cattle News
- Apr 04, 2019
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By Andrew Whitelaw | Source: Mecardo.
This article was bought to you by GE Silos.
The market is volatile, there is no mistaking that and every grain farmer in Australia will have experienced concern about locking in contracts only to have the crop fail, or not locking in and being exposed to falls in price. It is important to have knowledge of all the tools available to reduce risk when marketing wheat and canola, and in this article, we will discuss the use of a put option as a pre-harvest risk management tool.
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The put is an option contract that gives the owner the right to sell the underlying commodity at a specified price (its strike price) for a certain, fixed period (until its expiration). The use of options is common in the grain trade, but is relatively unused by grain growers. At Mecardo, we think there are opportunities to use options as part of a risk management strategy as a form of ‘insurance’.
In this article, we will discuss the use of a put option as a pre-harvest marketing tool, and how it would work in principle. The use of a put option would be used where you think a price is attractive but don’t want to take the production risk with a physical contract. The charts used in this example are for a hypothetical market, however would apply for wheat and canola.
If the grower thinks that the futures market is attractive, they can elect to take out a put option. If we use the analogy of insurance, the grower pays a premium which will provide a minimum price (Figure 1), this removes any exposure to the shaded green portion of the chart. This premium is paid upfront to your broker or bank. The premium will be dependent upon how close to the market the strike price is, and how much time until it expires.
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Figure 2 depicts the market rising. In this scenario, the put option would not be exercised as we would not want to sell the futures at a lower level than the market. The grower would then be able to participate in the upside, however would have to reduce any increase in price by the value of the premium paid on the option.
If the market falls, the grower however will have downside limited to the minimum price set by using the option (figure 3).
A full glossary of options terminology is available on our site by clicking here.
Key points
*The put option gives the right to sell the underlying futures contract.
* As a risk management tool, the put can be used to protect from downside, whilst giving exposure to any potential upside.
There is no risk of washout due to production failure.
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What does this mean?
The put option is a tool that gives the ability to have a known worst-case scenario for pricing futures (for a set premium), whilst still giving providing the opportunity to gain from a rising market.
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