Who doesn’t like free money? The answer is a lot of farmers, because few are picking up an easy, risk-free 10 to 20 cents per bushel on their in-the-bin crops by writing call options.
It’s an ignored revenue source thousands of farmers could access that not only offers a bit of a bump up in prices in a rising market, but also offers a small hedge in a falling market.
Advisers say writing calls makes sense for farmers with crops in the bin and who have price targets set.
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Here’s how it works. A farmer who has 500 tonnes of canola in the bin, which he plans to sell late in the winter or in the spring for a set price, say $410 per tonne, can write call options against that amount of crop at a higher price.
A call option is a right to buy something in the future at a set price. A call writer is a person who creates an option and sells it to someone else. In this case, the call writer is the farmer who issues the call option against the amount of crop he has in the bin.
For writing the option contract, the writer gets a premium. Usually a call option that is “out-of-the-money” by $30 to $40 per tonne can be sold on the Winnipeg Commodity Exchange for $5 to $8 per tonne, which translates to 10 to 20 cents per bu. A farmer who collects $6 per tonne on call options on 500 tonnes ends up pocketing $3,000 if the calls aren’t exercised.
Brokers are generally willing to establish a producer’s call options for 40 to 50 cents per tonne.
Out-of-the-money means that the exercise price for the call, which is the point at which it is profitable for the call buyer to implement, is higher than the market price today, so there is no risk of the call being immediately exercised. If today’s May canola price is $390, and the call’s exercise price is set $35 out-of-the-money, the call’s exercise price is $425 per tonne.
Many professional call writers take on substantial risk by issuing call options because they may have to supply the value of the commodity to the buyer if market prices move unexpectedly higher. But there is virtually no risk for a farmer who has crop in the bin because any loss on the exercise of the option will be made up by selling the physical crop.
If a farmer has already decided that he wants to sell his canola crop late in the winter for $410 per tonne, he might as well write a call option on the crop at a price point higher than that. The only thing the writer loses is the ability to collect a price higher than an exercise price that he never expected to receive anyway.
If you’re hoping to sell the crop for a lower price than the exercise price, why not sell a call against it? That 10 to 20 cents per bu. could end up being a large proportion of the crop’s profit, so it’s not something to be shrugged off.
Key to this marketing technique is holding onto the physical crop until after the call option expires. That way, if prices suddenly rise and the call option is triggered, the farmer-writer doesn’t have to scramble to buy suddenly more valuable crop to cover his obligation. He can simply sell his physical crop at the higher market price and use that real-world cash gain to cover his (apparent) loss on the call being exercised.
Of course, if the farmer had expected to sell his crop at only $410 per tonne and had set the call’s exercise price at $425 and had collected a $6 premium for writing the call, there’s no loss involved in settling the obligation at $425. Instead of selling the crop at $410, he’s selling it for $15 per tonne more, plus pocketing $6 per tonne as a premium. All he gives up is the ability to earn more than $425 per tonne, which he never expected to see anyway.
That’s a $21 per tonne gain.
If, on the other hand, the market price of the crop drops after the call is written, the farmer has already received a premium and that helps reduce the damage of the market price dropping. It’s a small downside hedge.
If the farmer wants, he can sell the physical crop if he expects the price to continue dropping. If the market price begins to rise again, he can buy back into it with futures contracts so that he’s still covered in case the option gets exercised.
Again, there’s virtually no risk to this strategy, and it generally earns the producer money he’d never otherwise see.
Trying out call option writing might be a good New Year’s resolution.
