Use of Crop Futures and Options by the Nontrader
North Central Regional Extension Publication No. 217 Fact Sheet #18
George Flaskerud, Extension Crops Economist, North Dakota State University
Richard Shane, Extension Economist, Grain Marketing, South Dakota State University.
Introduction
Commodity Exchanges for Various Crops
Implications of Trading Months
Relationship Between Futures and Cash Prices – Basis
Deriving a Potential Cash Price
Weighing Planting Alternatives
Determining the Profitability of Storage
Deciding to Sell or Feed Raised Grain
Significance of Option Premiums
Elevator Contracts
Marketing Strategies
References
Crop producers make a number of decisions that are market related. They may be categorized as financial decisions, production decisions, or marketing decisions. All three decisions depend on what prices are likely to be at some specific time in the future.
The marketing decision is complex. A number of alternatives are available, even for the producer who does not directly buy or sell futures or options contracts.
One alternative may be to sell the crop off the combine. Other alternatives may be to store the crop until some price objective is reached, to establish the price for the growing or stored crop by contracting for later delivery, to fix a favorable basis in a contract (but not the price) until a later time, to fix a favorable futures market price in a contract (but not the basis) until a later time, and to establish minimum or maximum prices in a contract. Decisions to fix the cash price, futures price or basis may be made on different dates.
Feeding the crop to livestock may also be an alternative. This creates an additional set of alternatives, since many of the marketing alternatives available for selling the crop are also available for selling livestock.
The futures and options markets can be used as a guide to evaluate marketing alternatives, since they provide the pricing mechanism on which elevators base forward pricing alternatives. The options market is based on the futures market.
A function of the commodity futures market is to discover the price that will balance expected supply and demand. Traders in the market are constantly analyzing all available information about supplies and uses of a commodity.
At times, traders may overreact in response to information and mass psychology, but eventually there is a correction in the market for excessive changes in prices. Market overreaction to the upside provides pricing opportunities for farmers through various elevator pricing tools, even if they choose not to use futures or options markets directly.
The futures market is useful for predicting prices, but only at a point in time. Given the current information about supply and demand, the futures price is what the market expects the price to be in that location at a specific time in the future. Expectations of supply and demand are always changing. When they change, futures prices also change.
In this publication the futures and options markets for agricultural commodities will be used to evaluate management alternatives for producers of crops. Characteristics of these markets will be examined. The relationship between futures and local cash prices will be determined and used to derive an expected cash price. Procedures will be covered for evaluating planting alternatives, for determining the profitability of storage and for deciding to sell or feed grain. The significance of option premiums will be analyzed. The many contracts offered to producers by grain elevators that are based on the futures and options markets will be reviewed. Finally, marketing strategies will be examined.
Commodity Exchanges for Various Crops
There are several futures markets for grains. Contracts on these markets are standardized as to delivery date and location, quantity and quality. Price is established through open outcry bidding in pits on a trading floor. The futures markets, commodities traded and sizes of contracts are presented in Table 1.
Table 1. Futures Markets, Commodities
Traded and Contract Size
Exchange Commodity Contract Size (Bushels) CBOT Wheat 5,000 Corn 5,000 Soybeans 5,000 MidAm Wheat 1,000 Corn 1,000 Soybeans 1,000 MGE Wheat 5,000 KCBT Wheat 5,000
Source: Derived from a table by Purcell, 1991.
Corn and soybeans are traded on the Chicago Board of Trade (CBOT) and on the MidAmerica
Commodity Exchange (MidAm). Wheat is traded on several exchanges: the CBOT, the MidAm, the
Minneapolis Grain Exchange (MGE) and the Kansas City Board of Trade (KCBT). The contracts
traded are 5,000 bushels in size, except on the MidAm where contract size is 1,000
bushels.
The size of the contract traded is the major difference between the CBOT and its affiliate, the MidAm. Since prices on the MidAm generally follow prices on the CBOT during trading hours they have in common, the discussion in this publication will focus on the CBOT but apply to both.
The CBOT wheat futures reflects mostly the soft red winter (SRW) wheat market, since this is the class of wheat that is usually delivered to that market when a seller of a futures contract decides to deliver the physical commodity on a contract. Similarly, the MGE represents hard red spring (HRS) wheat and the KCBT represents hard red winter (HRW) wheat. Contract specifications determine deliverable grades.
Deliverable grades of wheat on the CBOT include No. 2 SRW, No. 2 HRW, No. 2 Dark Northern Spring, No. 1 Northern Spring at par, and substitutions at differentials established by the exchange (Catania). Availability and transportation costs are key factors determining which grade is delivered.
On the MGE, the deliverable grade is No. 2 Northern Spring, 13.50 protein or higher, with premiums and discounts for deviations as established by the exchange. No. 2 HRW is the deliverable grade on the KCBT, with No. 1 and No. 3 wheat deliverable at differentials established by the exchange.
Delivery is an uncommon practice for the majority of traders. Most futures contracts are offset. When delivery occurs, it is usually done by an experienced trader (Purcell, 1991).
Wheat prices vary from one commodity exchange to the next. They vary because of supply and demand conditions for the underlying type of wheat, location of delivery facilities and delivery costs.
Producers should follow the commodity exchange that represents the class of wheat they produce. A producer should follow the MGE for HRS wheat, CBOT for SRW and KCBT for HRW. If a different exchange is followed, then some assumption must be made about the price relationship between the producer's type of wheat and the representative exchange.
Implications of Trading Months
The trading months are identified in this section relative to crop years. Differences between monthly prices (spreads) are analyzed and implications for management decisions are explained.
Months
Futures contracts are traded only for predetermined delivery months. Wheat and corn are traded for March, May, July, September and December delivery. Soybeans are traded for January, March, May, July, August, September and November delivery.
Commodity exchanges offer contracts in those months that best fit the production and marketing patterns for the commodities in order to maintain a high level of liquidity (Purcell, 1991). There must be enough contracts traded on a particular day to accommodate large and small traders without delay.
For example, the majority of U.S. wheat is harvested during June-August. The futures contract months of July, September, December, March and May are sufficient in number to discover the prices that balance supply and demand throughout the year.
Restricting trade to those months attracts enough speculators to provide adequate liquidity in each contract. Because speculators have limited capital, they must choose among investment opportunities. Trading in every month could cause liquidity to suffer in some contracts.
Crop Year
Futures contracts usually trade simultaneously for two different crop years (Sogn). One group represents the balance of the last crop (old crop), while the other group represents the next crop to be produced (new crop).
The months are called old crop or new crop months according to the time of harvest, which varies by class of wheat as well as by crop. For example, July is a new crop month for CBOT and KCBT wheat but is an old crop month for MGE wheat. November is a new crop month for soybeans, and December is a new crop month for corn.
Carrying Charge
The more distant futures contracts within a crop marketing year usually trade for a premium to the nearby contract months because of a carrying charge (Baldwin). A carrying charge is a market-determined return to cover costs for storage (interest, shrink and insurance), handling and management. The charge prevails when the trade wants inventories to be stored from harvest until needed for processing, feeding or exporting.
Corn futures prices on the CBOT closed December 11, 1992 at $2.12 in the December contract and $2.30 in the May contract. The carrying charge between December and May was $.18.
In contrast, wheat futures prices on the CBOT closed on the same date at $3.72 in the December contract and $3.48 in the May contract. In this case, the market was reflecting a discount for later delivery, in effect, an inverse or negative carrying charge. The inverse or negative carrying charge was the market's signal that wheat storage until May was to be discouraged and that current demand was stronger than expected demand five months later.
The futures market will tend to reflect a full carrying charge when grain stocks appear large relative to anticipated use. A full carry may also be reflected from the last old-crop month to the first new-crop month when the supply of new crop appears inadequate for projected use. In both cases, the market is providing an incentive for storage. In the first case, storage is encouraged to ensure that the large crop is taken off the market at the appropriate time, and in the second case, to supplement new crop supply.
Sometimes the more distant contracts within a crop marketing year reflect less than full carrying charges. They may also trade for a discount to the nearby contract, as shown in the 1992 wheat example. In effect, the market can be inverted. In these situations, the futures market may be reflecting a strong immediate demand for cash grain, anticipated future weakening of demand, or that the new crop is expected to be large.
With normal production prospects for the new crop, old crop typically trades for a premium to new crop. The premium is usually required to ration use of the limited old crop supply.
New crop may trade for a premium to old crop at times if the futures market is concerned about new crop supply. In this event, new crop futures prices will rise until the market perceives that enough additional resources have been attracted into production to ensure a sufficient supply, or that enough old crop grain is being stored into the next marketing year to relieve supply tightness.
Relationship Between Futures and Cash Prices – Basis
The local cash price is related to the futures contract price for a commodity (Flaskerud, March 1991). The relationship is called the basis. It is calculated as the cash price minus the futures price. Knowledge about local basis will help producers who use various elevator contracts decide whether the contracts offer favorable pricing opportunities, and which type of contract best fits their situation.
Deriving the Basis
Historical basis may be available from Extension (See References) or from the local elevator. It may also be calculated by collecting cash and futures prices from the local elevator over a period of time. Three to five years should be sufficient.
The nearby basis is derived by subtracting the nearby futures contract price from corresponding local cash prices. Futures prices during the futures contract delivery month should not be used, since distortions between the futures and cash markets can occur due to delivery pressures and work to the disadvantage of the hedger.
Let's say you want to look at the nearby basis for wheat beginning in July. The September futures price is subtracted from the local cash price until the last day in August. After that, the December futures price is subtracted from the local cash price until the last day in November, and so on.
An example is presented in Figure 1 for the wheat basis at Hunter, North Dakota, relative to the nearby Minneapolis futures (Flaskerud, May 1992). The basis is summarized as monthly averages and as three-year averages of the monthly averages. The three-year averages were derived by deleting the high and low monthly averages.1
Figure 1. Hunter wheat basis (relative to nearby
Minneapolis futures).
1The basis in Figure 1 was exceptionally strong during the spring in 1986. Although supplies of hard red spring wheat were plentiful during this time period, free stocks of higher protein spring wheat were apparently scarce. Substantial bushels of wheat were under loan and in the farmer owned reserve. A strong cash price relative to the futures price was needed to attract remaining bushels to the market.
Features of the Basis
For many U.S. production areas, the basis is negative for most commodities at the farm level. When this happens, it is described as being a number of cents under a particular futures contract price. When it is positive, it is described as being over the futures contract price. If the basis is more negative or less positive from a historical perspective, it is described as being weaker, and stronger when the opposite occurs.
The basis usually varies seasonally during the marketing year as well as from one year to the next. However, the variations within a year tend to follow a fairly predictable pattern, and annual deviations from the pattern are generally small relative to annual changes in cash grain prices. The pattern is reasonably predictable because of the carrying charge, arbitrage and transportation costs (Baldwin). Arbitrage occurs when grain elevators or others see price differentials that exceed transportation costs and re-direct shipments to profit from those differentials.
The carrying charge reflects the cost of holding inventories from harvest until time of sale, as discussed earlier. Consider the July corn basis, for example. As time passes, from harvest until the following spring and early summer, remaining storage costs decrease and cash prices should increase relative to futures prices; in effect, the July basis should strengthen.
Arbitragers make sure that the cash price at delivery points and the futures price converge at the time the futures contract terminates. They do this by buying grain in the low-priced market (cash or futures) to sell in the higher-priced market. Because of delivery charges and adjustments for quality, however, the cash price at delivery points will usually exceed the futures price when the futures contract matures or expires.
The price relationships among delivery points and other locations such as terminal elevators, milling elevators, country elevators, feedlots, and so on, are important because most grain is not shipped to delivery points. Transportation costs and final market destinations determine the relationships among prices at various locations. Because transportation and other costs generally increase over time, it may be necessary to use a slightly weaker (more negative) basis than history suggests.
The basis may fluctuate from one day to the next or deviate from the pattern from one year to the next for reasons not related to changes in costs. For example, the basis may be weak relative to the average basis if demand is lacking, if supply is excessive, or the transportation cost or supply outlook is uncertain. The amount of storage available in an area can have an impact on the basis, too. In general, anything affecting the flow of grain through the market system can have an impact on the basis.
Deriving a Potential Cash Price
The commodity futures market can be used to derive a potential local cash price. To do this the futures market price must be adjusted to reflect the relationship between the futures price and the local cash price. In effect, the futures price must be adjusted by the local basis.
The derived basis can be projected by comparing the recent basis level and pattern to previous basis levels and patterns for the same time of the year. The average or median may not be the most appropriate estimate of the basis, because of increases in transportation costs over time.
Subtracting the proper basis number from the nearby futures contract price will result in an estimate of the cash price. For example, the average basis during harvest at Hunter, North Dakota is $.25 under September futures (Figure 1). A Minneapolis September futures price of $3.35 would indicate a potential cash price in August of $3.10 at Hunter.
Weighing Planting Alternatives
Producers evaluate a number of planting alternatives each year. Flexibility in the government farm program since 1990 has generally increased the alternatives for many producers.
Potential cash prices can be used to evaluate planting alternatives when they are combined with other budget information. Crop budgets are usually available in extension publications, although using your own numbers is preferred.
Potential cash prices should be recalculated occasionally to determine if changes in the production plan are warranted. Key times may be after USDA releases the March 31 Planting Intentions Report or after Monthly Supply and Demand Reports and Weekly Crop Progress and Condition Reports.
Determining the Profitability of Storage
A framework for analyzing storage profitability is presented first, followed by a discussion of storage costs (Flaskerud, May 1992). This information is then applied to a North Dakota situation.
Framework for Analysis
A knowledge of the basis and storage costs provides the information necessary to evaluate the profitability of storage. This evaluation involves several steps (adapted from O'Connor and Anderson).
Begin by estimating the basis for each calendar month as discussed. Derive potential cash prices as explained.
The final step is to derive net potential prices for each month by subtracting variable storage costs from the localized prices. The month with the highest net local price is the month during which sales should be planned.
It must be emphasized that this procedure is only a tool for planning sales and choosing forward contract delivery months. If the differences (spreads) between futures prices change substantially and/or expectations of the basis change, then the plan should change too.
To be sure of capturing the potential net price, it would be necessary to establish a production or storage hedge or forward contract. To establish the hedge, the nontrader can use one of the contracts discussed later in this publication.
Storage Costs
Storage costs for two situations are presented. The cost of storage in an elevator is reviewed first followed by an analysis of on-farm storage costs (Reff).
If the grain is stored in the elevator, the cost of storage per month is the rate specified by the elevator plus an interest cost on the money invested in the grain. The monthly interest cost is the cash grain price times the appropriate interest rate, which is examined later in this section.
For on-farm storage in existing facilities, only variable storage costs need to be considered, and these are divided into two categories. The costs were based on a wheat price of $3.10 on the farm.
The first category of variable costs is comprised of expenses primarily associated with the grain going into and out of storage. It includes the costs of operating and repairing equipment, handling shrink, insurance, management, labor and trucking. The total cost of this category was estimated to be approximately $.08 per bushel.
The $.08 charge would be specified as a cost during the first month of storage only. Once the grain is in the bin, this cost is not important to the storage decision since part of it has already been incurred and the remainder will be incurred regardless of whether the grain is hauled out immediately or later.
The second category of variable costs includes a cost per month for interest on investment on the stored grain and storage shrink. Both costs are based on the cash grain price.
The Commodity Credit Corporation (CCC) loan annual interest rate was 3.5 percent and lender operating loan annual interest rates in North Dakota were about 9 percent during 1993. An average of the two was used in the calculations weighted by the loan value and the difference between the loan value and the expected wheat price. To achieve this weighted average interest rate, a producer would need to take out the CCC loan shortly after the grain is in the bin. Funds from the CCC loan would need to be used to repay all or part of any loans with a higher interest rate.
An alternative rate of interest would be applicable for those producers with no debt. It would be the potential rate of return from an investment of the proceeds of a grain sale.
Storage shrink is very small for properly designed and managed storage facilities. In the case of wheat, shrink represents a monthly loss equivalent to .05 percent of the wheat price.
Cumulative variable storage costs per month on the farm that were relevant to storage decisions made prior to the wheat harvest in 1993 are presented in Table 2 (preharvest). They include the total costs from both categories of variable costs.
Table 2. Cumulative Variable Storage Costs per
Month on the Farm for Wheat Produced in 1993
Months in Storage Pre-Harvest Post Harvest (cts/bu) (cts/bu) 1 8.87 1.42 2 10.29 2.83 3 11.71 4.25 4 13.12 5.67 5 14.54 7.08 6 15.96 8.50 7 17.37 9.92 8 18.79 11.33 9 20.21 12.75 10 21.62 14.17 11 23.04 15.58 12 24.46 17.00
Suppose that a decision was being made in August whether to sell wheat for delivery off the combine or to store until November. The relevant total storage charge to consider would have been about $.12 per bushel according to the preharvest storage costs in Table 2. To cover storage costs, a farmer would have had to get an additional $.12 per bushel in November, compared to the selling price for delivery off the combine in August.
Cumulative variable storage costs per month on the farm that were relevant to storage decisions made during 1993-94 after the wheat was in the bin are also presented in Table 2 (post harvest). They included only the total cost from the second category.
Suppose that a decision was being made in November whether to sell wheat for immediate delivery or to store until May. An additional six months of storage would have been considered. The relevant total storage charge to consider in this decision would have been about $.09 per bushel according to the post harvest storage costs in Table 2.
If storage is essential to harvesting efficiency, some producers may choose to include category one costs and several months of category two costs as harvesting costs instead of storage costs. For them, the post harvest storage costs in Table 2 would have been relevant to the sell/store decision.
Suppose that a producer had stored wheat to improve harvesting efficiency and that field work prevented delivering wheat to the elevator until November. If a decision was being made in November to either sell wheat for immediate delivery or to store until April, an additional five months of storage would have been considered. The relevant total storage charge to consider in this decision would have been about $.07 per bushel according to the post harvest storage costs in Table 2.
Application
Several examples are presented illustrating the impact of basis and storage costs on marketing decisions of a wheat producer. In each example, the producer was making a decision prior to harvest on whether to sell off the combine, to store unhedged or to establish a storage hedge. An example is also provided for corn. The producer in this example was making a decision to sell in November or continue to store. The examples are for a producer at Hunter, North Dakota.
The producer was confronted in the first example with the futures prices, basis and storage costs presented in Table 3 as of August 1990. The graph of the Hunter wheat basis relative to the nearby Minneapolis futures (Figure 1) was used to determine the basis in this example. For planning purposes, the three-year average basis was used.
Table 3. Timing Wheat Sales, Hunter, North Dakota, August 1990
Calendar Month Nearby Futures Month Nearby Mpls Futures Hunter Nearby Basis Hunter Potential Price Storage Costs Potential Net Price - - - - - - - - - - cents - - - - - - - - - - Aug Sep 278 -25 253 0 253 Sep Dec 289 -33 256 9.7 246 Oct Dec 289 -27 262 12.0 250 Nov Dec 289 -21 268 14.3 254 Dec Mar 301 -27 274 16.7 257 Jan Mar 301 -23 278 19.1 259 Feb Mar 301 -25 276 21.6 254 Mar May 307 -21 286 24.0 262 Apr May 307 -18 289 26.5 262
In this example, the market indicated that storage until March-April may be profitable.
The highest net price occurred in March-April when it was 9 cents per bushel higher than
at harvest.
To be sure of capturing the potential net price for April delivery, it would have been necessary for the producer to establish a storage hedge or forward contract. The risk in holding unhedged inventory until March-April would have been that cash prices do not increase enough to cover the cost of storage and could decrease. The risk in a storage hedge would have been limited to the basis risk. In a forward contract, all price risk (and price or basis improvement potential) would be eliminated.
Current and potential protein premiums also need to be considered when making a decision to sell or store wheat. There is not a way to lock in protein premiums while the grain is being stored.
There are times when a profitable storage hedge can not be planned, as the second example illustrates in Table 4. In this example, the market strongly indicated that as of August 1989 wheat should not be stored but sold at harvest.
Table 4. Timing Wheat Sales, Hunter, North Dakota, August 1989
Calendar Month Nearby Futures Month Nearby Mpls Futures Hunter Nearby Basis Hunter Potential Price Storage Costs Potential Net Price - - - - - - - - - - cents - - - - - - - - - - Aug Sep 393 -25 368 0 368 Sep Dec 398 -33 365 10.8 354 Oct Dec 398 -27 371 14.0 357 Nov Dec 398 -21 377 17.3 360 Dec Mar 406 -27 379 20.6 358 Jan Mar 406 -23 383 23.9 359 Feb Mar 406 -25 381 27.3 354 Mar May 406 -21 385 30.7 354 Apr May 406 -18 388 34.1 354
Storage of the 1991 wheat crop until January 1992 appeared profitable in the third example
presented in Table 5, calculated in July 1991. However, the potential net returns to
storage appeared small (5 cents), considering historically low prices and relatively low
risk of declining futures prices if the wheat was held unhedged.
Table 5. Timing Wheat Sales, Hunter, North Dakota, July 1991
Calendar Month Nearby Futures Month Nearby Mpls Futures Hunter Nearby Basis Hunter Potential Price Storage Costs Potential Net Price - - - - - - - - - - cents - - - - - - - - - - Aug Sep 275 -25 250 0 250 Sep Dec 285 -33 252 8.3 244 Oct Dec 285 -27 258 10.3 248 Nov Dec 285 -21 264 12.2 252 Dec Mar 294 -27 267 14.2 253 Jan Mar 294 -23 271 16.2 255 Feb Mar 294 -25 269 18.2 251 Mar May 294 -21 273 20.2 253 Apr May 294 -18 276 22.1 254
Storage of the 1991 corn crop until May 1992 appeared profitable according to the
calculations presented in Table 6. Potential net prices were computed in November 1991
using a median basis for 1985-1989 (Flaskerud, March 1991) reduced by $.05 per bushel. The
weaker basis was considered appropriate due to rising transportation costs.
Table 6. Timing Corn Sales, Hunter, North Dakota, Nov. 1991
Calendar Month Nearby Futures Month Nearby CBOT Futures Hunter Nearby Basis Hunter Potential Price Storage Costs Potential Net Price - - - - - - - - - - cents - - - - - - - - - - Nov Dec 241 -31 210 0 210 Dec Mar 251 -31 220 1.8 218 Jan Mar 251 -34 217 3.6 213 Feb Mar 251 -28 223 5.3 218 Mar May 257 -29 228 7.1 221 Apr May 257 -30 227 8.9 218 May Jul 262 -29 233 10.7 222 Jun Jul 262 -30 232 12.5 220
Deciding to Sell or Feed Raised Grain
Many producers can easily add a livestock feeding enterprise to their farm operation when the right economic conditions prevail. Producers frequently have facilities in place, making it necessary to cover only the variable costs of production if they decide to feed livestock.
An additional step needs to be added to the framework for analysis of storage to make a decision about using raised grain to feed livestock. This step involves comparing potential storage net returns to potential livestock net returns.
An example of potential net returns from a livestock enterprise (based on a budget by Aakre) and potential net returns from grain storage are presented in Table 7. The net returns represent a return to labor, management and facilities.
Table 7. Potential Corn Storage Net Returns Compared to
Potential Livestock Net Returns When Steers are Fed from
700 Pounds to 1204 Pounds in 163 Days
Item Amount (dol) Total Income ($74.00 per cwt) 890.72 Costs
- Beginning Value ($84.48 per cwt)
- Feed
- Other
- Interest on Operating Capital
- Total
573.62
164.01
56.10
35.62
829.35Return to Labor, Management & Facilities
- Livestock Net Returns
- Corn Storage Net Returns
61.37
5.46
In this example, a decision was being made in November whether to sell or store corn or
feed it to livestock and whether barley should be sold or fed. Continued storage of barley
was not considered a viable alternative in this situation except for livestock feeding
since the seasonal price pattern for barley (Flaskerud and Johnson) suggests November
sales.
The livestock net returns in Table 7 reflected the cash price expected when the livestock were sold. The potential cash price can be derived, using futures and basis, in the same manner as for cash grain sales.
The livestock net returns reflected a feed grain cost based on feed grain prices when the livestock enterprise was initiated plus a cost for storage shrink. The charge for interest on investment in the stored grain was included in the livestock budget as an interest charge on operating capital.
The corn storage net returns in Table 7 were derived from Table 6. The difference in expected net returns between November and May was $.12. Storage returns equaled $.12 x 45.5 bushels of corn fed per animal or $5.46.
A comparison of expected net returns, $5.46 from storage versus $61.37 from feeding, suggests a potential value added of $55.91 to the corn and barley by feeding it to livestock. This analysis should help the producer decide if a livestock enterprise should be initiated.
Significance of Option Premiums
Puts, calls and other features of the options market are briefly explained to facilitate an understanding of option premiums (see Campbell for more details). An example is given to illustrate how this information can be used as a guide for making marketing decisions.
How Options Work
Producers who buy put options have the right to sell futures at a specific (strike) price but not the obligation, and they do not have a delivery obligation. Also, margin money is not needed. An option is purchased by paying a premium.
Profit on a purchased put option is generally achieved by offsetting (selling) the put option at a later time for a higher premium than when it was purchased. At least the amount by which the price is below the strike price can be captured when the put option is offset. A greater amount could be captured if time value remains.
Call options are the right to buy futures at a specific (strike) price instead of to sell as in put options. But, a profit would be achieved in the same manner, in effect, by offsetting (selling) for a higher premium than when it was purchased. At least the amount by which the price is above (instead of below) the strike price can be captured when the call option is offset. As with put options, a greater amount can be captured if time value remains.
Implications
Option premiums reflect what traders feel at a moment in time about possible price movements. This information can be used as a guide for determining the direction of futures prices, thus in making marketing decisions.
To do this, option premiums for different strike prices need to be examined relative to the underlying futures contract price. A visual examination is usually very difficult, however, because of the many different strike prices for puts and calls which need to be evaluated.
A microcomputer program, called OPTIONS, has been developed (King, Fackler and Held) that derives price probability distributions from futures option premiums. The probability of a price decline by the option contract's last trading day is specified as part of the output. Examples in the User's Guide for OPTIONS illustrate the usefulness of the program.
Option-based probability assessments for the November soybean contract from July 1989 provide one example. In this case, prices increased sharply during late June and early July in response to forecasts of continued hot, dry weather. The November soybean price increased the limit of $.30 on July 5, but began to drift down on July 6 and 7.
The OPTIONS program indicated that the downward trend was likely to continue. Options premiums indicated that the probability of a price decline increased from 54 percent on July 5 to 58 percent on July 6 to 59 percent on July 7. Option traders believed that the soybean price was more likely to decline than rise prior to harvest that year, and their attitudes toward the market were reflected in different premiums for puts than for calls. This could have been interpreted as a signal to contract a portion of new crop production.
Elevator Contracts
Most elevators offer several types of contracts, which are based on the futures and options markets. The producer does not use futures markets in any of these contracts but a knowledge of futures concepts is essential to reaping the full benefits of their use. A producer can manage a substantial amount of price risk by using these contracts.
Production risk is a major disadvantage of contracts because delivery is usually required. If growing conditions make that impossible, either an arrangement must be made to meet contract obligations or a new contract must be negotiated.
Cash forward contracts (CFC), basis contracts, hedged-to-arrive (H-T-A) contracts, minimum price contracts (MPC), and delayed price (DP) contracts are some of the contracts that can be used to manage price risk. The best contract for a producer to use largely depends on current and expected (1) futures prices, (2) basis and (3) cash prices.
Cash Forward Contract
Farmers will often CFC a part of anticipated production, sometimes as much as 50 percent. The CFC is the most frequently used marketing tool for locking in a price prior to harvest.
The CFC can be evaluated by comparing the contract price to the potential cash price. The contract price will likely be lower due to the uncertainty of the basis.
A producer may choose to speculate that the basis will be stronger than what the contract price reflects. But, that requires use of an alternative such as the H-T-A contract or the minimum price H-T-A contract.
The possibility of drought and higher prices as well as the uncertainty of production is a disadvantage of the CFC. It may be desirable to use a contract with more flexibility.
Cash Forward Contract with Cancellation Provision
Contracts with cancellation provisions have been offered to producers by grain buying firms through local elevators. The cash price offered in these contracts is usually fixed and is lower than in a standard cash forward contract. But, the discount may not be as large as the cost of an option.
There may be a limit on the percentage of anticipated production which may be contracted in this manner. In one contract that has been used, that percentage was based on the multi-peril crop insurance yield.
In this same example, the farmer had to buy multi-peril crop insurance to participate in the program. This requires that production be determined by a third party if less than anticipated. If production is less than the amount contracted the producer is able to cancel the difference without penalty.
Basis Contract
There may be times when it is advantageous to fix a favorable basis but not the price. This can be done at elevators through a basis contract, sometimes called a basis fixed contract.
In this contract, the basis is fixed relative to a specific futures month at the time of the contract. The farmer then just watches the futures price. When a price objective is reached, the farmer can fix the futures price too. At this point, the basis contract is equivalent to a CFC (see Good for more details).
Hedged-to-Arrive Contract
The H-T-A contract may be useful in a situation where the futures price is considered acceptable but the local cash forward contract price appears too low relative to the futures. Sometimes called a basis open contract, the H-T-A contract is just the opposite of a basis contract. It accomplishes the same purpose as a regular futures hedge.
The futures price is fixed when the contract is initiated and the basis is established later. The basis can be fixed when it becomes more attractive or when the contract matures. The risk with this contract is that the basis may weaken instead of strengthen.
The elevator handles the futures position, including any margin money. The elevator may or may not charge a fee for this service. In return, the producer is committed to delivering the contracted bushels to the elevator (see Ferris for more details).
Minimum Price Contract
Cash contracts based on the options market are available through many local elevators. Referred to as MPC, they offer about the same price flexibility as put and call options. They differ from options in that a producer has a delivery obligation with the MPC. Another difference is that the relationship between the cash price and the futures price is fixed.
The basis fixed portion of the contract is calculated as the difference between the minimum selling price and the strike price. The producer can execute the basis fixed portion of the contract any time before the contract expires (see McDonald for more details).
For example, the difference between a September $2.80 strike price and a minimum price of $2.30 is $.50. This would be the basis fixed portion of the contract. The contract would be for a minimum price of $2.30 or $.50 under the September, whichever is higher. If the producer executed the basis fixed portion of the contract when futures are at $3.10, his price would be $2.60 or $3.10 minus $.50. In effect, the farmer receives the increase in futures price above $2.80.
Minimum Price H-T-A Contract
This contract combines features of the MPC and the H-T-A contract. Under the minimum price H-T-A contract, a minimum futures price is established initially (Ferris). The producer can later establish possibly a higher futures price. Regardless of what happens to the futures price, the basis is established later. The risk with this strategy, as in the H-T-A contract, is that the basis may weaken instead of strengthen (see Ferris for more details).
Delayed Price Contract
Grain can be delivered to the elevator and the pricing decision can be delayed until later with a DP contract. The producer receives a price based on the cash price posted in the local elevator rather than on the futures price. Knowledge of the basis is needed to determine if the posted cash price is appropriate given current futures prices.
Service charges specified in the contract would reflect anticipated changes in the basis. This type of contract leaves the producer exposed to both price level and basis risk, but service charges may be less than storage costs. Hence, it is often used as a substitute for storage (see Good for more details).
Marketing Strategies
Alternative crop marketing strategies for different expectations about futures prices and basis are presented in Table 8. The information is meant to be a guide for making decisions on marketing old and new crop.
Table 8. Crop Marketing Strategies
Expect Futures Basis Alternative Strategies Increase Strengthen
- Store
- Delayed Pricing Contract
- Minimum Price Hedged-to-Arrive Contract
Increase Weaken
- Basis Contract
- Minimum Price Contract
Decrease Strengthen
- Hedged-to-Arrive Contract
- Minimum Price Hedged-to-Arrive Contract
Decrease Weaken
- Cash Sales
- Cash Forward Contract (CFC)
- CFC with Cancellation Provision
- Minimum Price Contract
Source: Based on Pricing Decision Chart on Crops by Ferris.
Storage may be a profitable alternative if the futures price is expected to increase and the basis is expected to strengthen. If storage does not appear profitable, consider a DP contract or a minimum price H-T-A contract. The latter would be the least risky strategy since a minimum price is established.
A basis contract or MPC may be appropriate if the futures price is expected to increase while the basis is expected to weaken. In effect, take advantage of the strong basis and speculate on the futures price.
If the futures price is expected to decrease while the basis is expected to strengthen, take steps to lock in the futures price but leave the basis open. This can be done with a H-T-A contract or a minimum price H-T-A contract.
Sell the crop in the cash market or sell with a CFC or MPC if the futures price is expected to decrease and the basis is expected to weaken. The CFC with a cancellation provision and the MPC would be the least risky marketing tools to use for unharvested new crop.
References
Aakre, Dwight, Alternative Marketing Strategies for 1991 Calf Crop, North Dakota State University Extension Service Publication.
Baldwin, E. Dean, Understanding and Using Basis for Grains, Fact Sheet No. 8, NCR Publication No. 217, December 1986.
Campbell, Gerald, Primer on Agricultural Options, Fact Sheet No.1, NCR Publication No.217.
Catania, Patrick J., Executive Editor, Commodity Trading Manual, Chicago Board of Trade, 1989.
Ferris, John, Developing Marketing Strategies and Keeping Records on Corn, Soybeans and Wheat, Fact Sheet No.4, NCR Publication No.217, December 1985.
Flaskerud, George, Basis For Selected North Dakota Crops, North Dakota State University Extension Service Publication EC-1011, March 1991.
Flaskerud, George, "Impact of Basis and Storage Costs on Marketing Decisions, "Journal of the American Society of Farm Managers and Rural Appraisers, 56:7-17, May 1992.
Flaskerud, George and Demcey Johnson, Seasonal Price Patterns for Crops, North Dakota State University Extension Service Publication EB-61, August 1993.
Good, Darrel, Deferred Pricing Alternatives for Grain, Fact Sheet No. 2, NCR Publication No. 217.
Gunn, Steven P. and William W. Wilson, Use of Agricultural Options Among North Dakota Country Elevators, Agricultural Economics Miscellaneous Report No. 93, Department of Agricultural Economics, North Dakota State University, Fargo, N.D., February 1986.
Karlson, Nicholas, Brad Anderson, and Reynold Dahl, Cash-Futures Price Relationships, Staff Paper P93-1, Department of Agricultural and Applied Economics, University of Minnesota, St. Paul, Minnesota, January 1993.
King, Robert P., Paul L. Fackler and Patti A. Held, Options, Microcomputer Program, University of Minnesota Extension Publication AG-CS-3003-S, 1991.
Lutgen, Lynn, Wheat Basis Patterns from Selected Sites in Northeast Nebraska, Nebraska Cooperative Extension Publication EC 92-896-B, September 1992.
McDonald, Hugh, The Minimum Price Contract - A New Marketing Alternative, Fact Sheet No. 9, NCR Publication No. 217.
O'Connor, Carl and Kim Anderson, "Understanding Basis," Business Management in Agriculture: Volume III, Joint Project of the Cooperative Extension Service, Farm Credit Services and Chicago Mercantile Exchange, 1989.
Purcell, Wayne D. Agricultural Futures and Options Principles and Strategies, Macmillan Publishing Company, New York, 1991.
Purcell, Wayne D. Agricultural Marketing: Systems, Coordination, Cash and Futures Prices, Reston Publishing Company, Reston, Virginia, 1979.
Qasmi, Bashir A., Grain Basis Patterns for Selected Locations in South Dakota, Economics Research Report 92-6, Economics Department, South Dakota State University, Brookings, S.D., June 1992.
Reff, Tom, Determining Grain Storage Costs, North Dakota State University Extension Service Publication EC-801, July 1983.
Satrom, John P., Alfred K. Chan, and William W. Wilson, Commercial and Producer Applications Using Options on Grain Futures, Agricultural Economics Report No. 200, Department of Agricultural Economics, North Dakota State University, Fargo, N.D., May 1985.
Shane, Richard, Futures Market, Unpublished Manuscript, Economics Department, South Dakota State University, Brookings, S.D.
Sogn, Art, The Benefits of Grain Futures Even if You Don't Trade Them, South Dakota State University Extension Service Publication FS-622.
Wilson, William W., Hedging Effectiveness of U.S. Wheat Futures Markets, Agricultural Economics Report No. 165, Department of Agricultural Economics, North Dakota State University, Fargo, N.D., October 1982.
North Central Regional Extension Publications are subject to peer review and prepared as a part of the Cooperative Extension activities of the thirteen land-grant universities of the 12 North Central States, in cooperation with the Extension Service – U.S. Department of Agriculture, Washington, D.C. The following states cooperated in making this publication available:
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Reviewers: Robert Wisner, Extension Crops Economist, Iowa State University and Jim Hilker, Department of Agricultural Economics, Michigan State University.
North Central Regional Extension Publication No. 217 Fact Sheet #18
