| March 21, 2008 | Archived Issues |
Risk Management Squeeze
During the past two weeks, market price action for both the corn and soybean futures markets has resulted in technical sell signals. Broken uptrend lines, penetration of horizontal support, and a weekly key reversal in the soybean market are some of the technical signals triggered in the markets. Along with upside price goals, downside price traps can be an important part of a marketing plan. These downside price traps, or lower price targets, are prices that trigger sales if the market fails to reach upside price goals. The goal is to capture these prices after a market reversal and before the market declines further. This is usually a good marketing strategy. Unfortunately, this strategy does not work if sales cannot be made!
Many elevators have suspended the offering of most cash contracts (harvest delivery contracts, hedgeto- arrive contracts, etc.). Although most still continue to offer only basis contracts, this suspension of cash contracting has not allowed producers to capture favorable prices as the futures markets have turned sharply lower.
The recent record high grain prices have offered ônever seen beforeö selling opportunities. But, the negative side is that grain buyers have been overwhelmed with margin calls on futures contracts. Among the tools elevators use to manage price risk in handling grain is hedging cash purchases with futures contracts. Grain purchased during last yearÆs harvest and early 2008 new crop forward contracted sales by producers was hedged by futures sales. As prices continued to rally toward record levels, this resulted in large margin requirements to cover the elevatorÆs futures positions. Although hedges are sound risk management practices, they resulted in cash flow deficiencies and large credit needs. The elevator borrowings have approached or exceeded lender limits, resulting in a very worrisome credit/cash flow squeeze. While lower prices may relieve the situation somewhat, large margin risk continues to exist in volatile futures markets with expanding daily limits. The elevators have been forced to stop the ôcash bleedingö by suspending contracting of new crop sales by producers.
With cash contracts no longer available, producerÆs alternatives for managing price risk are severely limited. In this situation, capturing favorable prices will likely require the use of futures or options. The problem with using futures is that producers will be faced with some of the same margin risks, along with large cash flow and credit needs, that elevators have been dealing with. Using options may avoid some of the margin and cash requirements, but option premiums are costly in volatile markets and some option strategies may still include futures margin obligations.
Buying a put option effectively insures a futures price floor and is a relatively simple market strategy to use. Purchasing a put option provides the right to sell a futures contract at a stated price (strike price) with no obligation to accept that as a final price or deliver the grain. A major advantage of purchasing the put option is that, since there is no performance obligation, there is no margin requirement. The only cash outlay is for the option premium (cost) and the broker fees. The net protected or ôinsuredö futures price would be the put optionÆs strike price minus the option premium. The final net cash price would be determined by this insured futures price and the local basis. Since many elevators continue to offer basis contracts, the basis could also be locked-in with a basis contract if desired. However, due to expensive option premiums and weak basis bids, the net protected cash price may be disappointing, especially after some of the recent lofty price bids near the record futures price highs.
The premiums for an at-the-money (ATM) December 2008 corn put option, which is an option with a strike price at or very near the current futures price, is about 65 to 70 cents per bushel. Since the option is on a 5000 bushels futures contract, the total cost would be from $3250 to $3500 plus broker fees for each 5000 bushels of protected. An ATM November 2008 soybean put option premium is $1.45 or more, resulting in a total cost of at least $7250 plus broker fees to protect the price on 5000 bushels of soybeans. These are significant cash costs that add to other rapidly escalating production costs.
Option premium costs can be reduced by purchasing out-of-the-money (OTM) put options. These are put options with strike prices that are below current futures price levels. However, this lowers the net protected price and these options are not cheap either. A December corn put that is nearly 50 cents below current prices may still cost 35 cents or more per bushel. A November soybean put option that is one dollar or more OTM can cost 95 cents or more. Even with reduced protection levels, purchasing options can result in significant cash costs.
Strategies that combine buying and selling options may offer price risk management at lower net premium cost. The objective of these strategies is to purchase a put option that provides a better level of price protection and then offset the premium cost by selling (writing) an OTM option. There are a variety of combinations that involve purchasing puts and selling either OTM calls or OTM puts, depending upon market outlook and pricing objectives. These various option strategies along with the wide range of strike prices results in an almost endless number of possible combinations and strategies that might be used.
It is important to understand that the objective of most strategies that buy and sell options is to manage riskùthey do not eliminate risk! Selling an option incurs an obligation that may require entering into a futures transaction, if the buyer exercises that option, and margin funds may be required. While the net premium cost can be reduced and margin requirements may be less, potential cash flow and credit needs can be significant.
The risk management squeeze on elevators has resulted in a shift of the risk management burden to producers. When cash contracts are not available, price risk management is still possible. However, it becomes much more complicated and costly for producers to accomplish. Net prices may also be less desirable and it will likely require additional cash flow planning along with the potential for increased credit needs. The more complex option strategies may include margin requirements and a thorough understanding of the various components of the strategy, or confidence in the skills of the person recommending them, is absolutely necessary.