Anyone trying to buy an option to hedge their crop’s exposure is probably feeling vexed by volatility.
But brokers say more sophisticated trading strategies still allow farmers to use options and not spend a fortune.
“Option plays have certainly changed because premiums are massively inflated compared to what we’re used to,” said Union Securities broker Ken Ball.
Brokers are arranging option spreads so farmers can open the upside or protect against the downside of crop markets in an affordable way.
Options are like insurance policies for the buyer. A call option allows someone to buy something in the future at a certain price. It generates a profit if the price goes above the set level and the cost of the premium.
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A put option allows someone to sell something at a certain price in the future. It generates a profit if the price falls beneath that set price and the price of the premium.
Until recently the kind of calls and puts farmers would buy were affordable. But once the equity and commodity markets became volatile, option writers began demanding a much higher price for being willing to provide calls and puts.
Volatility, which is the amount prices are moving up and down in the markets, is more extreme now than it has been any time since 1987.
That’s why spreads come into the equation.
A spread involves a person buying an option and selling another. The sale helps cover the cost of buying the first option.
“Options spreading has become very popular because you can buy a call or a put option and sell an option further out-of-the-money and the option premium (of the one you sell), because of the extreme volatility, doesn’t go down very much,” said Ball.
“You can play the spread at a relatively narrow cost, even though the option you are buying is outrageously expensive, because you can sell an option further out against it and still get a good price and reduce your cost quite substantially.”
For many years, option spreads were not popular because the premium a writer could charge for a far out-of-the-money option was so low that it did little to subsidize the cost of buying a close-to-the-money option.
That was because volatility was so low that no one was willing to pay much for a far-out-of-the-money option that seemed to have no real chance of being used.
But these days, with huge price swings in the markets, those options don’t seem like such a bad bet to many investors and hedgers, so there’s a better market and much larger premiums.
Two weeks ago adviser Errol Anderson of Pro Market Communications was buying a client a “bull call spread” of a $4.50 per bushel corn call and selling a $5.50 corn call. That spread cost about 30 cents, which provides the farmer a chance to capture a $1 per bu. increase in corn prices at an affordable cost.
Buying the $4.50 corn call alone would have cost about 60 cents, which would have seemed like a bad deal to most growers.
