Options and Futures

This note is an updated and extended version of the note produced in 2006 promoting the use of options before the price rose (at that time the price of wheat for January 2008 was £75/t and option premium £3.85/t). 

Key Points

• Crop price is the major determinant of profitability and the volatility seen over the last few years is likely to remain – or even increase.
• Crop price and price movement is largely unpredictable.
• Options provide the safest means of managing risk but can increase exposure if poorly understood.
• Options are likely to increase in importance: in the UK approximately 10% of the crop is traded on the futures and options market while 100% is traded in this way in the US.
• It is almost impossible to imagine a professional farming business that does not at least occasionally use options.
• Options are also a cost as well as a benefit.

Option definitions

Put option:	The right, but not the obligation, to sell at an agreed price on the futures market.
Call option:	The right, but not the obligation, to buy at an agreed price on the futures market
To exercise an option	To take up the right to buy or sell the commodity at the agreed price
Expiry	The point at which the contract terminates.
Option premium	The payment made to buy the option (‘the insurance premium’).
Strike price	The price at which the option becomes valuable, or ceases to have value.
At the money	Where the futures price and option price coincide.
Out of the money	Where the agreed option price is above the futures price for a call option or below the futures price for a put option.  If the option were exercised the holder would lose money.
In the money	The reverse of “out of the money” above i.e. if the option were excised the buyer of the option would make a profit.

Options basics

Options can be considered as price insurance.  A payment is made and in exchange for the payment the purchaser may be compensated if an unexpected price movement occurs.  The premium is determined by the market and will increase with the risk of crop price movement and also with the length of the period covered.

A purchaser of a put option has the right, but not the obligation, to sell grain at the agreed price.

Thus in October 2007 the wheat futures price for January 2009 was £127.5/t.  For a payment of £12/t (the option premium) the buyer of the option would be able to sell at £127.5/t (the strike price) if he wanted to.  If the price increased he would not sell at this price and would simply lose the £12/t.  If the price fell to say £90/tonne, he would exercise the option giving the right to sell at the £127.50/t gaining £37.50/t less the £12/t option cost.

Conversely, the purchaser of a call option has the right, but not the obligation, to buy grain at the agreed price.

Thus in October 2007 the wheat futures price for January 2009, as stated above, was £127.5/t.  For a payment of £11.5/t the purchaser of the option could buy wheat at £127.5/t (the strike price) if it was worth doing so.  If the price fell he would not exercise the option, so losing the £11.5/t since there would be no point in purchasing wheat at above the market price.  However, if the price rose to say £160/t (again), he would exercise the option giving the right to buy at the £127.5/t gaining £32.5/t less the option cost (£11.5/t).

It is not necessary to wait for the end of the option period to take up the option (said to be exercising the option) and if the January 2009 futures price shot up to £160/t in March 2008 it would be possible to exercise the call option (in the example) at that time, achieving the same result as described.  However, this could still be below the market peak, and for example, in 2003/4 and 2007/8 many traders and farmers who had taken out options cashed in at below the peak.  While the option should ensure the minimum acceptable price it does not guarantee the peak and closure should be over a period of time determined by the view on risk.

For both put and call options it is possible to set the contract up to buy the option at a price other than the futures price.  For example, when purchasing the call option you might not mind missing out on an increase in price of £5/t but would be upset to miss out on a higher increase.  This reduces the price although in general when adding the cost of the option and the price rise foregone the cost is higher.

Thus on the 28^th October 2007 the January 2008 Call option prices quoted by Liffe were:

 

Strike Price £/t	Option Premium
162	6.15
165	4.95
175	2.15

Note underlying price £160.5/t

 

The reverse situation applies for put options.  The purchase is said to be out of the money.

The option cost varies.  The greater the interval is until expiry of the option, the higher the cost, and the greater the perceived risk, the higher the premium.  The premium is determined by the market perception and is not necessarily a mathematical calculation.

Options relate to the futures and operate in the same months as the futures markets.  The current operating months are: January, March, May, July and November.  LIFFE wheat options expire on the second Thursday of the calendar month preceding expiry month.  Minimum contracts are 100 tonnes and the minimum price movement is £0.05/t.  The period over which trading can take place varies with month and can change from year to year.

There is also a transaction cost. This is by negotiation but should be no more than 20p/tonne.  Some of the organisations operating in this field charge £1/tonne and justify the cost as a management charge.  Some will also be acting as an intermediary using another party to set the premium. 

The ex-farm price will typically be lower than the futures price by around £2-£3/t i.e. the cost of transport to store in areas of excess production (e.g. East Anglia). However, in areas of deficit production (e.g. Scotland) the ex-farm price will typically be higher than the futures price by around £2-£3/t. The relationship between the ex-farm price and the futures price is known as basis. 

Using options to hedge risk

In contrast to a speculator, a farmer has a physical crop to sell.  This opens up a number of additional possibilities to manage risk.

Using a call option to manage risk

Purchase of a call option together with sale of the physical crop has been the most commonly used options hedge in UK agriculture largely because it is easy for grain traders to manage since they have control over sale of the crop to ensure payment and do not have to ask for money up front.

The farmer purchases his call option and simultaneously sells his crop forward for the same month.

Action
Purchase call option for January 2009	Futures price £127.50/t less cost of option at £11.5/t
Wheat sold forward for January 2009	Crop sold £124.50/t (equivalent to the futures price £127.50 less the cost of transport £3 (this varies from about £2-£4/t)

 

 

Situation 1 Price increases to £160/t (futures)
	Calculation
The farmer receives proceeds from the sale of the crop less the option cost	£124.5-£11.5 = £113.0/t
Farmer takes up the option to buy at £127.5/t and sells it back on to the futures market at £160/t	£160/t(sale)-£127.5/t (cost) = £32.5/t
Total Return	£113.0/t+ £32.5/t = £145.5/t

 

Situation 2 Price falls to £90/t (futures)
	Calculation
The farmer receives proceeds from the sale of the crop less the option cost	£124.5-£11.5 = £113.0/t
The option is left unexercised
Total Return	£113.0/t

 

Of course, if the farmer had simply sold he would have been better off in one of the two situations but assuming that the minimum return secured a profit he at least knew that he would not make a loss and had the potential to achieve a higher return.

This situation can more clearly be illustrated in a risk diagram.  The x (horizontal) axis shows the market price, rising and falling by £20/t.  The vertical axis shows the impact on the farmer using the option hedge described above. 

Using a put option to manage risk

To hedge using a put option, the put option is purchased while the grain is not sold until expiry or until the contract is exercised.  Put options are used less frequently by farmers largely because the sale of the crop and purchase of option are separated so a payment has to be made. 

Action
Purchase put option for January 2009	Futures price £127.50/t less cost of option £12.0/t
Wheat crop left unsold until expiry of option

 

 

Situation 1 Price increases to £160/t (futures)
	Calculation
The farmer receives proceeds from the increased crop value (futures price less transport and option cost)	£160 – £12.00(premium) – £3.0 (transport) = £145/t
The option is left unexercised
Total Return	£145/t/t

 

Situation 1 Price falls to £90/t (futures)
	Calculation
The farmer receives lower proceeds from the sale of the crop (futures price less transport and option cost)	£90 – £12.00(premium) – £3.0 (transport) = £75/t
The option is exercised allowing the contract to make a profit over the prevailing futures price	£127.5(sale)- £90(purchase)=£37.5/t
Total Return	£112.5/t

 

While the apparent impact is similar the late sale can be used to advantage in protecting the underlying price of quality wheat. 

For example, to sell milling wheat forward prior to harvest is high risk since if the quality is not achieved the contract would usually still have to be fulfilled and the price of buying in may well have increased dramatically.  Indeed, at least one grain group has found itself with severe financial problems from doing just this.  On a falling market the benefit of a large milling premium may only return the milling wheat price to the feed wheat price if it had been sold earlier in the season.  The results produced by several of the marketing groups show this is exactly what happened in their pool sales following the 2004 harvest.  The problem is compounded by the tendency for the milling premium to increase when the feed wheat price is low.  The alternative conservative approach is to sell milling wheat only after harvest when the quality is known. 

The use of a put option allows the selling window for milling wheat to be increased.  Substitution of milling wheat in the example above would have allowed the additional milling premium to have been achieved on top of the feed wheat protection.

Other pricing considerations

If there was perfect knowledge of the market the use of options would simply be an unnecessary additional cost.  However, the annual fluctuation in prices is largely unpredictable although it is possible to provide some information on the probability of a price movement.  Where World and EU stocks are low there is a greater chance of high prices than when both stock levels are high.  The probability will increase or decrease over the growing year as data becomes available on factors such as planted area, frost kill and drought.  Unfortunately the vast majority of the world’s crop is produced in the northern hemisphere with harvest in the second 6 months of the calendar year (and even Australia tends to harvest in December).

The EU support arrangements effectively provide a free put option.  However the support is far less certain than a purchased option and will for example always be vulnerable to exchange rate movement and EU management decisions.  The support is also ineffective when UK wheat quality is low.  Nonetheless it is a consideration that should be taken into account when using options; an option would be doubly as expensive if the protection it provided simply duplicated the support arrangements.  While it might be expected that the option cost would also reduce to reflect support arrangements it does not appear to; since this is a unique feature of the EU cereal market it may not be fully appreciated by traders working in other markets.

Calculation of cost of production and target return is a prerequisite of any marketing strategy but is often more complex than it seems at first glance since allocation of costs may be difficult, particularly where livestock is also on the farm.  Land farmed on contract farming agreements may also cause problems with different prices being acceptable to the two parties involved.  It is quite common for production of wheat to cross-subsidise other crops such as peas, beans or even oilseed rape.  Conceptually the Single Payment Scheme income will also have an influence on the cost of production; land is needed to activate the payment and it may be legitimate to exclude the cost of land from the calculation of the cost of growing a crop.

Options can be used to support indecisive management.  Where the price is high enough to produce a profit and there is an equal probability of an increase or fall in price, a simple sale will leave the producer better off than a sale with the purchase of an option.  However, a single sale at that price would be considered risky (despite securing profit) and many growers would cautiously sell only some of the crop, risking a loss on the remainder.  The use of an option guarantees a profit and still allows some uplift in price. 

Analysis of grain sales in May for the following January shows that either selling forward or delaying the sale may have been the best course of action over the last 5 years. However this could only be known in hindsight, so sales in May with an option contract for the following January on average has produced a better return than consistently selling forward or selling spot in January.

More sophisticated option management

There are a number of other possibilities that can improve risk management:

1.     Call options can be taken out some time after the sale of a crop.  They will usually be cheaper because they will be closer to expiry and there are periods of the year when the risk of price fluctuation is lower.  However, if the futures price has increased over the period this may easily remove the benefit of the deferred purchase.

2.     A call option might be taken out for a period that is closer than the month when the crop is sold.  For example, the option might be taken out for January to guard against the major unknown of world production in the autumn, and consequent price swing, while the crop may be sold in May taking advantage of the storage facilities available.

3.     Once purchased, options may be sold on (usually at a lower price than the purchase cost). This may reduce the cost of the option if a decision is made that a change in price is less likely (e.g. if a call option has been taken and the price has fallen by £20/t).

4.     Where the price rises dramatically and the use of a call option has secured a profit it is quite possible to close out the option, to secure the uplift in price, and then take out a second option in case there is a further upwards movement or to protect against a subsequent fall in the futures price.  Purchase of two options increases the cost, compared to leaving the first option open, but also provides a higher minimum price.  Cashing in a January 08 option this year at £170-190/t, even with the cost of purchasing a new option (producing no gain at the time of writing) would have been a better strategy than waiting until now where the market is currently under £160/t. 

5.     Options can be granted/sold with the receipt of income rather than cost.  If not understood this can be expensive since the commitment is open-ended – the sale of a call option for £10/t may increase the price at that moment to £10/t above the futures price but if the price moved from, say, £125/t to £175/t the person providing the option would have to find the additional £50/t.  This may be offset by unsold grain in store which would have increased similarly in price.

6.     There is no need to use a single hedge for all the grain.  It would be quite reasonable to sell, say, 100% of the crop but take out a call option for only 50%.  The risk diagram for this using the same data as in the example shows:

As can be seen the cost and upside have been reduced compared with the 100% call option and sale.

Similarly, a call option on 100% of the crop and sale of 50% of the crop change the risk-reward balance yet again:

7.     An important specific example is the producer’s fence/hedge.  This achieves a collar with a minimum price and maximum price for no cost.  The farmer writes (grants) a call option (this may be out of the money) and uses the money to buy a put option (this may also be out of the money).  The grain is sold when the option expires potentially to fund the call option cost if the price rises.

Deriving an approach

Many sellers of grain tend to adopt a similar strategy each year and those selling at the highest price one year will often be the lowest price sellers in the following year.  It is good practice to list marketing targets in terms of minimum acceptable price and the period over which sales (physical or options) should be made to take advantage of price movement.  It is too easy to over-react to upwards or downwards movements.

As a general principal it is worth selling crop as far forward as storage and cashflow allows since on most occasions the extra cost of interest foregone on deferred payment will be more than compensated for by the increase in price.  However, the option should cover the period most at risk of a price movement. 

The major period at risk is from harvest until November.  The reasons are at least in part explained by the accuracy of the production forecasts.  There are several organisations that forecast production but the most readily available, and most widely used, are produced by the USDA.  The crop estimates improve in accuracy over the season and as reliability of estimate increases, the scope for price changes reduces.  In fact in 5 out of the last 10 years the greatest change in price between months occurred in September or October (sometime after most of the US wheat harvest) and these movements were greater than the harvest depression (which accounted for 4 out of the remaining 5 years).

Reliability of USDA wheat production estimates (deviation from final estimate (M t))

Source: USDA

 

The end of the season can also result in considerable price movement partly in response to anticipation of the following harvest and partly in response to end-of-season shortages.  A late harvest can force up the price if stocks are low.  This situation may well be exaggerated this year where prices are expected to be lower after harvest so buyers’ stocks may well be low.

As a risk management strategy the first task is to determine whether a put or call option is appropriate.  In most circumstances, they are roughly interchangeable when used as part of a risk strategy.  However, as explained previously the opposite strategy must be taken with the physical crop – so if the crop is sold forward the right to buy the crop back with a call option is appropriate, while if the crop is unsold the use of a put option provides protection against the risk of price fall.

The latter strategy is appropriate where the wheat crop may have some quality characteristics and helps to secure a guaranteed underlying price with the premium on top if achieved.  It can help to ensure that the premium, if achieved, is on top of an acceptable feed price and not on top of a collapsed post-harvest price.  Obviously if the price rises the only cost is the option cost.

It is much easier to market a crop when the price is high because a sustainable profit can be secured even after the option cost.

Volatility is clearly high now so cost is relatively high although not exceptional in percentage terms.  If the price really is not going to move up or down by the cost of the option there is no point in using the option but this would be unusual.  To sell 50% forward now and wait to sell the remaining 50% until the end of the season is unlikely to achieve a higher price than selling all with an option now.  Selling all the crop now, or all in the future, might secure a better price but this is likely to be by chance.

Once an option has been taken it is important not to close it out in one go.  For most growers the objective is to protect against the major price movement from harvest until December and ignore the more speculative changes.  In an exceptional year such as following the 2007 harvest it might be reasonable to close out the option and then reinvest the option either for the same expiry date or further forward.  This costs more money but secures a higher minimum price.

It is important to make sure that before call options are closed there is absolute certainty that there is sufficient physical crop to fulfil existing contracts – the option helps overcome the problem of under-delivering on a low-priced contract and being forced to buy in at a higher price.