Options contracts are good solution in volatile markets

Hog futures could explode.

Cash hog prices could crash.

Corn prices could soar.

Grain prices could slump.

Markets always go up and down, but this summer is hosting much more potential for explosive volatility than most years, without even considering regular supply and demand issues.

It’s a perfect time to use options contracts to hedge that volatility, and options could allow a producer to forward-price cash sales with buyers while still leaving most of the bull market potential intact.

“You want to be vigilant about protecting against the event of an (African) swine fever outbreak through the use of options,” Dennis Smith of Archer Financial Services said during the Global Hog Industry Virtual Conference.

His comments came after he laid out a bullish scenario, in which the world finally realizes that Chinese hog herd losses are far worse than thought now, causing U.S. lean hog futures to “explode.” Then he pondered what would happen if ASF broke out in the U.S., causing all international pork and hog markets to close.

This is a medium-term outlook containing both extreme bullishness and extreme bearishness as opportunities and threats balance on the scales. It’s risky to hedge with futures in these circumstances, when suddenly the cash and futures markets can become completely divorced, as would happen if Canada was hit with ASF.

It’s also risky to not arrange for delivery of hogs in a future that may contain a 1998-like crash if the borders are closed.

Call options allow a farmer to price now and lock-in delivery while leaving the upside open. Put options can allow a farmer to leave his cash price open while insuring against an unexpected price crash.

“They’re particularly good when there’s a lot of weather uncertainty, or a lot of political uncertainty,” said David Derwin of P.I. Financial when I called to chat about the situation.

Beyond the ASF opportunities and threats being presented to hog producers, there is huge uncertainty about the weather in the U.S. corn belt, with tens of millions of unplanted acres, and gigantic political uncertainty between Canada and China, as canola growers already know.

Futures hedges can create more risk than they hedge against when there are political or disease issues looming over markets, like now.

As always, the problem with options is that they cost money to buy, which isn’t true of futures. Premiums can go up when markets are volatile, like now.

But there are ways to subsidize them through spread strategies that involve buying and selling differently priced options, opening up a window for gains if the market goes the right way.

It’s not the kind of thing most farmers will do by themselves, so I’ll leave it to brokers to explain to farmer-clients how to do it. But it’s worth asking your broker about, or getting a broker.

This could end up being a great year for hog farmers and a good year for grain growers, if today’s trends persist. But there’s much more risk of a price collapse for Canadian growers too.

That makes this a good year to look at options.

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