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Consider A Put Option In Volatile Markets

Canola prices for all futures months had surged much higher from last June to a high set in early February. Some farmers were pricing “new” crop canola during the rally. However, many farmers are reluctant to contract physical grain delivery this far ahead of harvest. Also, many farmers were held back by a common fear — that is to price some crop and then have the market immediately rise to a higher level than their locked-in price. When canola prices are at historically high and profitable levels, however, it is a good idea to consider a way of capturing those prices on at least part of your expected production. A canola put option purchase using your own commodity account is one such consideration.

An option is a subset of the futures market, and is specific to a certain commodity and a futures month for that commodity. Purchasing a put option gives the buyer of that option the right, but not the obligation, to enter into a “sell” futures position at a predefined price (called the strike price) anytime before that option’s expiry date, regardless of what the futures price does. Unlike a sell futures position (or a deferred delivery contract) where the price is locked in at a certain level, the put option buyer is still able to take advantage of a higher futures price if the market offers that opportunity.

Currently, and unfortunately, canola is the only Canadian grain commodity that trades with any volume in futures or options. Volume of trade is not great with canola options, but they do trade.

HOW PUTS WORK

Here is an example of a put option purchase using numbers from the recent ICE Canada canola market:

There are two parts of an option premium — intrinsic and time value. Intrinsic value is what the option would be worth as a futures position if it was exercised, and can never be negative. There would be intrinsic value in the November put option only when November futures is below $580/tonne. As of February 9, there was no intrinsic value since the November futures was above $580/tonne at $605/ tonne.

The other part of an option value is time, which is the risk premium.

As of February 9, all of the $25/ tonne value of the put option was time. Two main factors affect time value, and they are time itself and volatility of the underlying futures price. If an option is exercised, any time value in that option is immediately extinguished. Until expiry of the option there is usually some risk in that option, so it is better to try to capture some return of that time premium by selling the option as an option rather than exercising it.

The premium (value) of an option is subject to change by open market trading whenever the futures market is trading. Canola option strike prices are $5/tonne apart, so there are many strikes prices available. On days when a particular option strike price does not trade, the commodity exchange uses a computer program to estimate the daily settlement value of that option.

LIKE A FLOOR PRICE

The purchase of a 580 put option at a cost of $25/tonne (plus commission) could be interpreted as locking in a minimum futures price. If all the original premium (cost) was eventually lost, buying that option can be considered as locking in a minimum futures price of $555/tonne (580 strike price MINUS the $25/tonne premium). If the futures price falls from the February 9 level of $605/ tonne, the premium of the $580 put option will tend to rise. If the futures price rises, the value of the 580 Put option will tend to fall. But, if the futures price rises, it implies that the value of physical canola is rising (subject to basis). If kept to expiry on October 21, and if then the option has intrinsic value (i. e., November futures is below $580/tonne), the 580 put option would be automatically exercised, thus creating a profitable futures “sell” position (not considering the original cost of the option). That sell futures position would then have to be offset at some point before the November futures expires.

Note that buying a put option alone would still leave the basis portion of price open. Leaving the basis open can be a good thing if basis levels for the expected delivery period are currently not acceptable (i. e., too weak), or if one does not want at the time to commit to a physical sale to a buyer. The put option is attractive to farmers who are concerned about committing to a delivery with the possibility of a crop shortfall (on quantity or quality), or to those who have already forward contracted to their comfort level.

WORKING IN THE BASIS

On the other hand, if the basis offered by a buyer becomes acceptable and committing to a

certain delivery tonnage is within one’s comfort level, then signing a basis contract with that buyer is a reasonable strategy. That could be done anytime, and is an independent decision from buying the put option. Signing a basis contract combined with the purchase of a put option effectively creates a minimum cash price contract. Using the 580 put option as an example, if a basis contract was available and signed at $15 under November futures, the combination of the basis contract and 580 put option would set a minimum cash price of $540/tonne (580 MINUS 25 MINUS basis of 15), excluding brokerage commission. That is, a minimum cash price is set, but you could still take advantage of higher futures prices than the strike price of your put option.

Continuing with this example, if November futures rallied during the upcoming growing season to $700/tonne, you could then turn your basis contract into a fixed price contract at $685/tonne ($700/tonne futures MINUS $15/tonne basis). You could still keep your put option. If the November futures price subsequently fell from $700/ tonne to $520/tonne by October, your 580 put option would then be worth at least $60/tonne (580 strike price MINUS $520 futures), and you would still net about $34 ($60 MINUS $25 cost MINUS $1 commission) on the option purchase and sale.

Here is an update of the example November 580 canola put option.

In the wake of the events of Japan, grain futures prices fell dramatically, with November canola futures falling to $523/tonne on March 16. On the same date, the premium of the 580 put option, which cost $25 on February 9, is quoted at $80/tonne. Note that the option value increased by only $55/tonne while the futures fell by $82/tonne. That is because the option’s time value (risk) dropped faster than the intrinsic value increased.

A critical first step in planned marketing is to know your costs of production for each crop, and then use that information as a base for establishing profitable price targets. We have been very fortunate this year to have profitable pricing opportunities for old and new crop canola, notably for the top grades. In these circumstances where available selling prices far exceed production costs of most if not all producers, it is much easier to justify spending some money to buy price insurance.

NeilBlue,P.Ag,writesfromVermillion,Alta. andspentmuchofthiswinterteachingmarketing coursestofarmerskeenonlearning newstrategies

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February 9, 2011 November Canola Futures = $605/Tonne November $580 Put Option Premium Quote = $25/Tonne Purchasing That November 580 Put Option For $25/Tonne (Plus About $1/Tonne Commission) Would Give You The Right To Create A Sell Futures Position In Your Account At A Price Of $580/Tonne Anytime Up To Expiry Of That Option On October 21. It Is This Right That Gives The Option A Value. However, You Do Not Have To Exercise The Option (I. E., Create The Sell Futures Position). It Is Generally Better To Just Trade Out Of (Sell) The Option As An Option Rather Than Exercise It, And You Can Do That (In A Liquid Market) Any Trading Day After Buying It.

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An option is a subset of the futures market, and is specific to a certain

commodity and a futures month

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