Option spreads may be better than buying puts or calls

Crops have held up so much better than most other asset classes that call and put options are still viable hedging tools.

However, to make them a safer and more affordable bet, some advisers are recommending option spreads as opposed to simply buying puts or calls.

“You can set a range of prices and reduce the premium,” said David Derwin of P.I. Financial in Winnipeg.

“It’s maybe where one needs to find strategies that are more appropriate than just buying puts or calls.”

Bear put spreads are being talked about a lot now, with the autumn market a big question and many farmers worried about how far prices could fall.

A bear put spread involves buying a put close to at-the-money (the present market price) and writing a put at a lower strike price. That way the premium earned from the lower priced put subsidizes the cost of paying the premium for the higher priced put.

The effective premium is much lower and opens up a window between the two prices which will compensate an asset holder for a price drop into that range.

Premiums tend to widen out during periods of volatility, and even though crops have been firmer than most other assets, they have been rocked around enough that premiums have gotten more expensive than a couple of months ago, when they were cheap.

Cattle puts were very affordable a few months ago, and Errol Anderson of Pro Market in Calgary said that has saved some feedlots’ bacon in recent weeks as the cattle market swooned.

“That has really, really worked,” said Anderson.

Some puts were bought for a premium of about $2 and sold for $17-$20, which is excellent compensation for the market slump.

Anderson said whether it’s crops or livestock today, farmers and others in the industry seem keen on locking in prices through selling futures, revealing a profoundly bearish outlook. Many farmers are willing to pull the trigger now on November prices without leaving the upside open to them.

However, if a farmer just wants some insurance against new crop downside rather than a locked-in price, a bear put spread can still be employed and is worth considering.

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