When is cheap better than free?
When what’s cheap contains no surprises and what’s free ends up causing big financial headaches, says Errol Anderson of Pro Market Communications.
That’s why he focuses on option strategies for crop sellers and buyers and why he’s promoting call option spreads and put option spreads.
A futures contract could be considered free because it costs only a broker’s commission.
An options contract, on the other hand, costs money up front, similar to an insurance premium.
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However, by creating a spread, the option buyer can buy an attractive call or put at far less cost than if he buys the option alone. The spread is created by buying the option desired, which will be close to “in the money,” and selling an identical option further “out of the money.”
Anderson has recently created put option bear spreads that work like this: on Sept. 6, Anderson had bids out at the Chicago Board of Trade for a combination of buying an $8 per bushel put option on wheat, and selling a $7.50 put option.
That creates a spread, or a “window,” of 50 cents per bu., which the spread buyer might gain if the market drops as Anderson expects.
At the time I spoke to him, he was waiting to hear whether options writers would take him up on the spread, but he hoped he’d be able to buy the spread for about 20 cents per bu.
Up to that point, as wheat prices rose, he’d been buying put option bear spreads of $7.50 to $7, which means the options contract holder can exercise the option if wheat prices fall to less than $7.50 per bu. on the Chicago contract.
If the spread cost 15 cents, the buyer is in a net-profitable position as soon as the price falls below $7.35. If the price falls to $7, the spread buyer has a profit of 35 cents per bu., which is nice if you’re a farmer holding a lot of grain in the bin or a feedlot operator who has bought a lot of expensive wheat while prices were rising.
If the buyer had decided to buy only a put option at $7.50 without selling the $7 put, the cost would have been far greater: about 43 cents per bu. That means that if the wheat price falls to $7, the put holder has only a seven cent profit rather than the 35 cents of the spread.
However, the real gains for the nonspread buyer kick in if the price plummets: if the price falls to $6.50, the put owner stands on a net profit of 57 cents per bu.
The spread holder caps out his profit at 35 cents, no matter how low the wheat price falls.
If the price collapsed, to $5 for example, the nonspread buyer would walk away with $2.07 per bu. while the spread holder can still get no more than the 35 cents of the spread.
As soon as the price falls to less than $7, the lower priced put is triggered, ending the spread’s potential gains.
Anderson was forming these bear spreads on wheat because he’s bearish on the crop. He thinks wheat has risen too high, too fast and is ready for a setback.
“Never in my life have I seen these things hold,” Anderson said about the recent wheat rally.
But spreads can go in the opposite direction. Recently Anderson has also been buying bull call spreads on corn for his feedlot operator clients.
He’s buying $4 December 2008 calls and selling $4.50 calls for a premium cost of 15 to 17 cents. That gives holders the ability to get a 33 to 35 cent gain on corn any time until late November 2008 if the price rises to or past $4.50.
Anything over $4 brings back at least some of the premium cost and generates a profit if the price rises over $4.15 to $4.17.
There are also call option bear spreads and put option bull spreads.
Anderson said he’s finding spreads work well for many feedlot operators and farmers because they are affordable and don’t contain the danger of the gut punches that volatility often brings to futures contracts.
“There are no margin calls,” said Anderson. “It keeps you away from the volatility.”
So why not try spreading out your risk some time? Spreads aren’t free, but they’re an affordable way to use options while taking on almost no risk.
