By Jon Scheve, Superior Feed Ingredients, LLC
Last March the corn market lost 30 cents after the USDA surprisingly increased stock levels. Last week the USDA surprised again but with a big drop in corn stock levels, resulting in a 20-cent market rally. The reason for the adjustment isn’t clear. Some think it was because last year’s yield was lower while others say more animals were on feed. Regardless, it’s keeping prices from going lower until yields are determined, which won’t be for a month or two.
Corn re-ownership strategies
I’ve described how to choose which crop should be stored at home during harvest and if farmers should pay for commercial storage. When making those storage decisions I explained that futures shouldn’t be included in the evaluation because farmers can reown grain using futures or an option strategy. While there are countless ways for farmers to re-own grain, the following shows two strategies most often used and the pros and cons of each.
Re-ownership using options: Buying calls
In this strategy a farmer sells their grain for cash and then buys a March call trying to capture upside potential. Buying a call is buying the right to own grain at a predetermined price called the strike price. This strategy is recommended because it limits loss potential to an upfront cost (i.e. the cost of the call option) while leaving unlimited upside potential.
While this sounds positive on the surface, there are hidden issues with this strategy. First off, there are numerous variables determining the call’s value:
• How long until the call expires, in this case March options expire Feb 21st
• How close the call is to being “in the money” which is the difference between futures value and strike price purchased
• General belief of where the market could be headed or volatility which determines the value of the call.
Following shows how the costs of buying different March call options shifted from before to after last week’s USDA report.
As of the Friday after the report March futures increased 13 cents; however, the cost/value of the call didn’t increase the same amount. It only increased 4 to 8 cents depending on the strike price.
Maybe the most common choice among the options above would have been to sell cash grain at $3.84 futures and buy calls at a $4.00 strike price for 9 cents before the report. However, if the March futures continues to trade at or below $4.00 for the next 5 months, the value of the $4 call will probably never exceed the 14-cent value it is today. Without a rally above $4 the call will eventually work its way to zero value. The call buyer is then out all of the 9 cents they paid for the option before the report.
Re-ownership buying a futures contract
The strategy that best resembles what farmers do when storing unpriced grain in a commercial facility is selling cash grain and buying a futures position at the same time. Let’s assume the same scenario above, a farmer sold for cash corn last week and immediately reowned March futures for $3.84 hoping for a future rally. With $3.97 futures now, the buyer is ahead 13 cents on the trade.
Which trade is better?
Both trades have risk, so the question I would ask is, “what do you expect from the market?” If you expect the market to go higher, buying futures is better because you get 1 for 1 price movement. Buying calls only gets 1 for 2 price movement during the first part of a rally. If you expect the market to tank, buying calls may be the better solution, but even then, why not also sell more bushels or even sell some corn for a different crop year to minimize the risk of loss on the purchase of the call if you believe that prices are likely to go lower.
However, the futures buyer will be behind a call buyer if futures drop below $3.75 in this example. The most a call buyer can lose, in this case, is 9 cents from the trade. If we subtract that value from the cash price collected at $3.84, we are left with the price where the futures buyer or call option are basically at the same breakeven point. However, if the futures prices continue lower the futures buyer has unlimited downside loss potential. In other words, buying futures does worse than buying calls when the market goes significantly lower than the cost of the call option.
I tend to dislike buying calls because of the odds against them making money. In the 3 possible market scenarios (i.e. up, down or sideways), buying calls will only make money in 1 of the 3 possible outcomes, if the market goes up a lot. Call buyers will lose money in a sideways or lower market. That’s 66% of the time buying calls will not be successful.
Futures buyers, on the other hand, will be more profitable than call buyers in 2 out of 3 market scenarios. I also would take into consideration the time of year for using futures instead of calls. Post-harvest prices tend to improve until around July 4th, so buying futures has less risk during this time. Prices tend to drift lower from July 4th to harvest, so buying calls has less risk during late summer.
Re-ownership through buying futures, or buying calls, or even leaving unpriced grain in commercial storage all have risks. And unfortunately, reducing risk means also reducing reward. Everyone has different risk tolerance and profit goals, but it’s important to think through your goals and have a plan. The statement, “I want to make the most I can” is not a satisfactory plan, because it doesn’t provide risk parameters or attainable goals.
Please email email@example.com with any questions or to learn more. Jon grew up raising corn and soybeans on a farm near Beatrice, NE. Upon graduation from The University of Nebraska in Lincoln, he became a grain merchandiser and has been trading corn, soybeans and other grains for the last 18 years, building relationships with end-users in the process. After successfully marketing his father’s grain and getting his MBA, 10 years ago he started helping farmer clients market their grain based upon his principals of farmer education, reducing risk, understanding storage potential and using basis strategy to maximize individual farm operation profits. A big believer in farmer education of futures trading, Jon writes a weekly commentary to farmers interested in learning more and growing their farm operations.
Trading of futures, options, swaps and other derivatives is risky and is not suitable for all persons. All of these investment products are leveraged, and you can lose more than your initial deposit. Each investment product is offered only to and from jurisdictions where solicitation and sale are lawful, and in accordance with applicable laws and regulations in such jurisdiction. The information provided here should not be relied upon as a substitute for independent research before making your investment decisions. Superior Feed Ingredients, LLC is merely providing this information for your general information and the information does not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision. The contents of this communication and any attachments are for informational purposes only and under no circumstances should they be construed as an offer to buy or sell, or a solicitation to buy or sell any future, option, swap or other derivative. The sources for the information and any opinions in this communication are believed to be reliable, but Superior Feed Ingredients, LLC does not warrant or guarantee the accuracy of such information or opinions. Superior Feed Ingredients, LLC and its principals and employees may take positions different from any positions described in this communication. Past results are not necessarily indicative of future results.