Managing Price Risk with Options Contracts
Any farmer who markets commodities knows the meaning of price risk—risk resulting
from the possibility that the price of a physical commodity may decline. While no farmer has
absolute control over the price he will receive for his farm products, tools are available that can
reduce his risk of commodity price fluctuations. One such tool is the option contract.
An option on a commodity futures contract is the right, but not the obligation, to buy (call
option) or sell (put option) an underlying futures contract at a specified price (strike price). To
obtain this right, a farmer pays an option premium, which is the cost of the option. Option
premiums vary in accordance with strike price, the current value of the underlying futures
contract, and the amount of time until the option expires. Options can be purchased on various
futures contracts and at various strike prices.
The beauty of buying options as part of a marketing plan is that the farmer buying the
option knows at the outset how much he stands to lose by purchasing the option. The maximum
amount the option buyer can lose on a put or call is the option premium. Because an option does
not obligate the buyer to exercise his right to buy or sell the underlying futures contract, the
owner can only lose what he paid to obtain the option. However, if the price for the underlying
futures contract changes such that exercising the option would be profitable for the farmer, he
can exercise or sell the option to improve his financial position.
Consider the following example that depicts how a put option can fit into a marketing
plan.
John grows corn and wishes to reduce the risk that the price he receives for his of corn
will go down. It is mid-summer and the local cash contract price for fall delivery is $7.90 per
bushel. Because John is uncertain about whether the cash price will be higher in the fall, he does
not want to forward contract, but he does want some price assurance. To this end, John decides
to purchase put options on the December futures contract. John chooses a strike price of $7.60 on
the December contract and pays a premium of 50 cents per bushel for the put options. This action
provides John some price support by giving him the option to sell December futures contracts at
$7.60 per bushel. If cash prices go down, John can exercise his put options and sell December
futures contracts at $7.60 or he can sell his options. Since cash and futures prices tend to move
in the same direction, if cash prices decline, the nearby futures contract prices should also
decline, which would afford John the opportunity to capitalize on his options purchase. If cash
and futures prices go up, John can either hold his options until expiration or he can try to
recapture some of the premium he paid by selling his options before they expire.
To learn more about how options can fit into a farm marketing plan, visit
www.extension.missouri.edu. There you can find several publications that explain futures and
options contracts in greater depth.
By: Whitney Wiegel, Agricultural Business Specialist, University of Missouri Extension