Put options are an extremely useful tool in a farmer’s marketing toolbox that have many benefits. Puts help to establish a floor beneath the market, while leaving the topside open. They can be used in a bullish environment to protect a stronger price level or can be used in a bearish environment to protect against further possible weakness. It is important to understand how put options work and to know some of the strategies that can be implemented using this tool.
The owner of a put option buys the right (not the obligation) to sell the underlying futures contract on or before the expiration date. Typically, the owner of a put option is someone who wants to establish a floor against lower prices. A dairy producer can use this tool to achieve a minimum price for his milk at a fixed cost. This provides peace of mind to the producer, in that he knows the lowest price he can get for his milk, while remaining in a position to achieve a higher price if the market strengthens.
There are several benefits to using put options in a marketing strategy:
- The first is the nature of the put option. That is, outright buying puts is fixed risk*. Producers know going into the position their maximum loss*. If the market strengthens and the put option goes worthless, it is not necessarily bad, because the topside is not capped, and your physical commodity is worth more. If the market weakens and the put option pays off, the producer could be in a better position than the market price.
- A second benefit is the ability to get in and out of the position. Producers can lock in profits as prices fall and the put gains value, or exit the position at breakeven or a small loss as prices strengthen and the put loses value.
- Finally, with put options, a producer can hedge milk on a monthly basis instead of a quarterly basis like Dairy Revenue Protection insurance. This can help avoid averaging issues if one month in a quarter settles a lot higher than others.
A couple more elaborate strategies that can be used with put options include bear put spreads and min/max (or fence) positioning.
- In a bear put spread strategy, the producer purchases a put option with a strong strike price right near the market, and sells a put option with a weaker strike price below the market. The purpose of the spread is to reduce the cost of the higher strike put by collecting the premium for the lower strike put.
- In a min/max (fence) strategy, the producer buys a put option and sells a call option. The producer collects premium for the call option to help pay for the put option. This position essentially “fences in” the price of milk within in a window: a minimum and a maximum price. It is important to note that selling options brings additional margin risk versus simply buying a put.
Knowing how to use put options can help take farm marketing to the next level. As stated above, this marketing tool can take risk off the table and can allow farmers to participate in a rally even if a put option is already in place. At Total Farm Marketing, we have been helping farmers manage risk and have been building strategies using tools like options for over 30 years.
*Risk and loss for these types of options is limited to the cost of the option, brokerage fees and related transaction fees. These fees vary from firm to firm.
© 2020 Total Farm Marketing
Total Farm Marketing and TFM refer to Stewart-Peterson Group Inc., Stewart-Peterson Inc., and SP Risk Services LLC, all part of the Total Farm Marketing family of companies. Stewart-Peterson Group Inc. is registered with the Commodity Futures Trading Commission (CFTC) as an introducing broker and is a member of National Futures Association; Stewart-Peterson Inc. is a publishing company; SP Risk Services LLC is an insurance agency. A customer may have relationships with all three companies. Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. This material has been prepared by a sales or trading employee or agent of Total Farm Marketing and is, or is in the nature of, a solicitation. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Total Farm Marketing.