Take an option to protect your profits

14 May 1999

Take an option to protect your profits

Selling grain on the spot

market has become

something of a lottery.

Prices are the lowest for

years in real terms, and

volatility has increased

markedly. This special focus

examines some tools and

ideas that can help farmers

regain control. Suzie Horne

starts with a look at the much

under-used futures market

ARABLE farmers have their work cut out if they want to sell their grain effectively.

May 99 wheat futures have traded at £72.50-£87.50/t in the past 10 months. This huge spread was due to currency factors and a drop in the $ price of wheat.

The intervention price does little to protect returns. Although fixed monthly in k terms, the sterling value is subject to daily change depending on exchange rates. Since January, it has fallen almost £5/t (see graph).

One way of protecting income is to use grain futures/options. The futures market trades in lots of 100t of either wheat or barley for given months, though physical delivery rarely takes place.

Options contracts are the main area of interest to growers. These give the right, but not the obligation, to buy (a call option) or sell (a put option) a set tonnage of a commodity at a set date at a set price.

Tim Mayhew of Glencore Grain explains how they work. A grower may have to sell grain in October on to a depressed market. He expects the price will rise before the end of the season but does not want or is unable to hold grain for that long.

"Many growers are forced into selling for cash flow reasons and that may be the wrong time from a market point of view," says Mr Mayhew. "Often practical constraints such as needing the store for cattle or lambing lie behind an ill-timed sale," he adds.

A typical strategy might be to sell physical grain for November (say, at £75/t ex farm), and buy a corresponding tonnage of May (futures) call options, £81/t at the time of writing. "This might cost him £4.25 to £4.50/t, and will be in profit if the May futures price rises above £81/t by more than the premium," says Mr Mayhew. Glencore Grain UK offers options as a service to growers when buying physical grain, deducting the premium from the payment for the physical contract.

The grower can then look at the futures market at any point and know if his option is in profit.

If, in the above example, the May futures price rises to, say, £93/t, the grower could exercise his right to buy at the £81 strike price and make a profit of £7.50-£7.75/t after accounting for the premium.

If the May futures price falls, then he lets the option lapse and needs take no action, though he still pays the cost of the premium.

This cost varies, depending on the perceived value of the risk to the party granting the option. This depends on the length of time from the point the option is granted to its expiry date, the strike price (the price at which the holder can exercise his right to buy or sell) and the percentage volatility of the market at the time.

Farmers reluctance to use options is mainly due to this cost. "But it could be a lot less than getting the market wrong," says Mr Mayhew. "Growers will consider whether to use a third or fourth fungicide and will make that decision based on whether there is a return on it. That is the way they should look at options.

"What it gives you is the right to be wrong," says Mr Mayhew. "But it does not negate the need to make a decision, based on correct market information."

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