Whether you have a legal, tax, insurance, management or land issue, Farmers Weekly’s Business Clinic experts can help. Here, Savills’ Andrew Wraith explains how options contracts can reduce grain price risk.
Q I keep hearing about the use of options in grain marketing as a means of managing risk and protecting income for a business. How do they work and what are the level of costs involved?
A There are two types of option: a put option and a call option, which can be considered much like an insurance policy.
A put option is effectively the buying of “insurance” against a fall in grain prices without removing the potential to sell your physical crops at a higher price in the future.
In the same way as you take insurance out for a tractor or any piece of equipment, the hope is that it will not be necessary to make a claim, but should there be an incident you are covered for the value of the item at that period in time.
It is obviously far more agreeable to be able to sell the physical crop at a higher price but if the market should fall you are guaranteed a pre-determined price for the crop.
In practice, a grain merchant offers to buy 300t of your wheat at £140/t for November 2018. You decide not to take it because there is some prospect of a market increase but the prospect of a significant market collapse isn’t affordable.
Director, Savills food and farming
Instead you are prepared to buy a put option through a broker based on November 2018 futures at £145/t.
It costs £8/t so for 300t the cost is £2,400.
If the market stays strong and goes up, whatever the grain is sold at, then £8 premium is effectively lost but the upside is on the physical sale.
If prices fall back then once futures drop below £136/t you make money on the option after taking the cost of the option into account to add to the physical sale of any wheat, effectively locking out a minimum base price for the wheat.
A call option is “insurance” against upward price movements. If you have a lack of storage for grain or need to sell some crop to ease cashflow, a call option will enable you to still benefit from a rise in grain prices.
Because the physical crop has already been sold you are not at risk from falling prices and your risk is limited to the cost of the premium you have paid for the option.
You buy a call option at £145/t for November 2018 for 300t priced at £8/t and this starts making money, allowing for the cost of the option once the futures price goes above £153/t.
There are two ways of buying options. Either via a Financial Conduct Authority registered broker, through whom you set up an account, or over the counter via a merchant or grain trader.
In both cases the option still needs to be monitored and managed to ensure it achieves what it sets out to do.
The costs of buying options are valued on three variables: strike price at which the underlying futures price is set; time value – how long the contract has to run; and volatility in the market.
The strike price is the level at which you look to take protection against price volatility and is based upon the difference between the agreed level at which the call or put option is activated and the actual futures price at the same point in time.
As with any insurance policy, the longer the time period, the greater the premium. So a harvest option which expires in November may cost £3/t, whereas an option expiring in the following May might cost £7/t.
Market volatility is also factored into the price. During a period of bad weather when the market is more volatile, the cost of purchase will be higher than during a period of market stability.
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