Corn strategy #2: Buying put options against bought corn

Marketing

by Matt Mattke

The second in a three-part series, this column covers buying put options against bought corn.

Corn feed buying agreements should be simple, flexible and give both parties greater control over the price paid or received. One simple feed contract for both the dairy producer and corn grower is a “pick your price” contract. The corn grower simply decides when he wants to lock in his sales price with the dairy producer. Depending on the time of year and the corn grower’s market savviness, that time could be an ideal buying opportunity for the dairy producer, or it could be the most inopportune time.

Last month, I discussed selling futures against bought corn. This month, I’ll address a second strategy: buying put options against bought corn. The great thing about this strategy is the dairy producer doesn’t have to determine whether it is an opportune time to buy or not.

Example

Suppose the corn grower decides to sell 30,000 bushels of corn to the dairy producer at $4.50/bushel. The dairy producer does not know whether corn will go higher or lower from here, but she does know that $4.50/bushel is a very high price to pay for corn.

Historically, corn futures have traded anywhere from $2.00-$8.00/bushel, so there is a couple dollars of potential movement in either direction. By having the corn bought, her risk of higher prices is eliminated, but to protect against lower prices she immediately buys put options.

She buys six December $4.25 corn put options at 35¢/bushel each (each contract is 5,000 bushels). These December put options establish a floor price on the bought corn at $3.90/bushel.

The table below illustrates how these December $4.25 put options would impact her $4.50 purchase price under several different market scenarios.

The table shows that if the December corn futures price falls to $2.00/bushel, the gains from the put options help to lower her net purchase price to $2.60/bushel. If corn rallies and goes to $6.00 or $8.00, she pays a net price of $4.85/bushel. She has $4.50 locked in with the corn grower, and with a 35¢ loss on the put options, her net purchase price is $4.85/bushel; leaving her with a worst-case purchase price below $5.00/bushel.

Advantages

There are several advantages of protecting bought corn feed with put options:

1) The dreaded task of trying to time the market is eliminated.

2) Put options are fixed risk positions, so the dairy producer knows her total cost of the position upfront.

3) It is a quick and simple strategy to implement and does not require daily management.

4) It gives the dairy producer the best of both worlds in the event of a big move in either direction. If corn goes to $8.00/bushel, the bought corn provides protection; if corn goes to $2.00/bushel, the bought put options provide protection.

Disadvantages

1) If the market goes higher, put options add to the producer’s corn price.

2) The upfront cost to establish the put options can be sizeable if the producer is buying a lot of bushels.

3) Put options do not have an infinite life. Corn put options do have an expiration date; December corn puts expire at the end of November.

In the end, the advantages outweigh the disadvantages, and this strategy can greatly simplify and speed up the entire feed-buying process.

Next month, the last article in this three-part series will cover the strategy of buying cash corn and protecting that feed purchase with a fence position.

Table 1. Corn price direction scenarios and impact on the
price dairy producer pays for corn ($/bushel)

What if the corn

price goes to:                                $2.00           $4.00            $6.00            $8.00

Floor price established

by put options:                              $3.90           $3.90            $3.90            $3.90

Gain or loss

of put options:**                         $1.90           ($0.35)         ($0.35)         ($0.35)

Price locked in

with corn grower:                    $4.50               $4.50              $4.50            $4.50

Final price locked in

after put options gains

or losses ($4.50 minus

gain or plus the loss)**:       $2.60               $4.85               $4.85             $4.85

** Commissions and fees with placing the futures trades is not included in these examples, but must be factored into final gain and/or loss of sold futures positions

FYI

• Matt Mattke, Market360® adviser at Stewart-Peterson, can be reached via e-mail: mmattke@
stewart-peterson.com, phone: 800-334-9779 or visit www.stewart-peterson.com.

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