E-142 RM2-22.0
6-02

Jason L. Johnson and Wade Polk*

The use of put options is a common pricing strategy used by agricultural producers to provide protection against price declines that can occur throughout the production year. A put option on a futures contract gives the buyer the right to sell the underlying commodity at a specified price (its strike price) for a certain, fixed period of time (until its expiration). As opposed to a short hedge (selling a futures contract) which "locks in" an expected selling price, the purchase of a put option in a marketing strategy allows an agricultural producer to establish only the "minimum" expected selling price while retaining the potential to benefit from price increases. Both strategies are subject to basis risk. Before grasping the rolling up a put option strategy it is important to understand the basics of futures and options. For further information, please refer to "Selling Hedge with Futures (RM2-14.0/L-5252)", "Introduction to Options (RM2_2.0/L_5256)," and "Hedging With a Put Option (RM2_12.0/L_5250)" in this series.

This article focuses on extending the use of put options to include "rolling up" put options to improve a producer’s minimum expected selling price when the price of the underlying commodity increases and retaining the upside potential of further price increases. Rolling can be defined as a trading action in which the trader simultaneously closes an open option position and creates a new option position at a different strike price, different expiration month, or both. Rolling up a put option, as prices increase, simply entails buying a put option with a higher strike price, while simultaneously selling the previously purchased put option with a lower strike price. In this manner, a producer can raise the price floor (or minimum expected selling price) that is created with the purchase of a put option.

The strategy of rolling up a put option when prices increase retains all of the advantages and disadvantages attributed to using put options as a typical marketing tool. The advantages include limited financial risk (limited to the put option premium), no margin calls, and more pricing opportunities throughout the marketing period. The disadvantages of put options are generally related to the put option premium values, which must be paid by the purchaser up front and that premium price changes may not equal futures contract price changes. Another facet of the option premium is that the time value component generally erodes, or decreases, with the passage of time. This decrease accelerates as the option contract approaches expiration. The strategy of rolling put options up as prices increase also requires additional commission costs to be incurred as trading activity is increased.

The extent of the producer’s liability with a put option is limited to the premium paid for the put option. The premium paid for the put option is equivalent to the premium paid for an insurance policy. No matter how much the price of the underlying commodity decreases in value during the option's lifetime, the put guarantees the investor the right to sell futures at the put's strike price until the option expires.

An agricultural producer utilizing put options on agricultural futures contracts retains all

benefits of commodity ownership during the lifetime of the put option and, for the amount of production hedged up to the quantity hedged with the put option, has "insured" the value of production against a decrease in price during the lifetime of the put. If the producer loses concern over a possible decline in price for his production and the put option has market value remaining, the option may be sold. This action can be risky however because the price could fall after the put is sold. If the put option expires with no value, no action need be taken; the producer will simply market the actual production at a price at or above their minimum expected selling price. If the option expires in_the_money (futures price closes below the put option strike price), the producer can elect to exercise their right to sell the underlying futures contract at the put's strike price. Alternatively, the producer may sell the put option, which has intrinsic value equal to the strike price less the futures price (plus any remaining time value), before the market closes on the option’s last trading day. The premium received from the sale of the put option will roughly offset any decline in the futures price. In this way, the put option provides the producer with a viable risk management strategy which provides limited and predefined downside market risk. The one risk that the hedger is still exposed to is basis risk.

With options, you can tailor your position to your own financial situation, commodity market outlook and risk tolerance. The minimum expected selling price (MESP) established with the purchase of a put option can be calculated as:

MESP = Strike Price - Put Option Premium - Commissions and Interest +/- Expected Basis.

Higher levels of strike prices for put options command higher premiums. Therefore, a producer can choose a strike price which balances their desire for an acceptable price floor with the required premium they must pay for this price insurance.

To examine the consequences of using the strategy of rolling up put options for downside price risk management, let’s begin with the action of buying a put option. Assume an expected basis of $0.60 per bushel under the futures price and commission and interest charges of $0.02 per bushel for each trade. In September, the July wheat futures contract is trading at $3.60 per bushel. Further, a July wheat put option with a $3.60 strike price (at-the-money) is trading for a premium of $0.20 per bushel. Since this put option is at-the-money, the entire $0.20 premium represents time value.

Action: Buy a $3.60 (strike price) put option which establishes a minimum expected selling price (MESP#1) of $2.78 per bushel.

                                        MESP#1 = strike price - put option premium - commissions and interest +/- basis

                                        $2.78 = $3.60 - $0.20 - $0.02 - $0.60

Scenario 1: Wheat Prices Decrease

If the July wheat futures price decreases from this initial level, the put option will gain intrinsic value. If the July Wheat futures contract were trading at $3.00 per bushel at expiration, the producer would receive approximately $0.60 per bushel from the put option ($3.60 strike price minus $3.00 futures).

Selling price of wheat at local delivery location:           $2.40 per bushel ($3.00/bushel - $0.60 basis)

+ Realized Gain from Put Option:                             + $0.60 per bushel

- Put Option Premium Paid:                                      - $0.20 per bushel

- Commission and Interest:                                         - $0.02 per bushel

Final result                                                                    $2.78 per bushel

 

The effective selling price of $2.78/bushel (subject to basis risk) is equal to the minimum expected selling price established with the put option. Thus, the put option provided downside price protection. In this example, basis did not change any from what was expected. Had the basis moved up or down, the effective selling price would have changed accordingly.

Scenario 2: Wheat Prices Increase - Rolling a Put Option Up as Price Increases

Suppose that in February, the July wheat futures contract has increased to $4.00 per bushel. The July wheat put option with a $3.60 strike price is trading for a premium of $0.02 per bushel and the July wheat put option with a $4.00 strike price is trading for a premium of $0.18 per bushel.

Action:

Sell the $3.60 put option you purchased in the previous scenario for $0.02 per bushel and buy the $4.00 put option to roll up or increase the minimum expected selling price (MESP#2) to $3.00 per bushel.

        Net premium paid = (premiums paid) - premium received

        $0.36 = ($0.20 for $3.60 put + $0.18 for $4.00 put) - $0.02 from sale of $3.60 put.

        MESP#2 = strike price - net premium paid - commissions and interest +/- basis

        $3.00 = $4.00 - $0.36 - $0.04 - $0.60

Result:

Rolling up the put option allows the producer to raise the price floor, or minimum expected selling price, to $3.00/bushel, an increase of $0.22/bushel above the $2.78/bushel (MESP#1) established with the purchase of the initial $3.60 strike price put option. If prices decline from this point, the producer can expect to receive no less than $3.00/bushel subject to basis risk.

Suppose that in April, the July wheat futures contract has increased again to $4.50/bushel. A July wheat put option with a $4.00 strike price is trading for a premium of $0.02/bushel and the July wheat put option with a $4.50 strike price is trading for a premium of $0.12/bushel. Notice that the at-the-money put option now trades for a smaller premium. This is quite common because the time value of a put option decays as the contract approaches expiration.

Action:

Sell the $4.00 put option for $0.02 per bushel and buy the $4.50 put option to increase the minimum expected selling price (MESP#3) to $3.38/bushel.

Net premium paid = (premiums paid) - (premium received)

$0.46 = ($0.20 for $3.60 put + $0.18 for $4.00 put + $0.12 for $4.50 put) - ($0.02 from

sale of $3.60 put + $0.02 from sale of $4.00 put).

MESP#3 = strike price - net premium paid - commissions and interest ± basis

$3.38 = $4.50 - $0.46 - $0.06 - $0.60.

Result:

Rolling up the put option again allows the producer to raise the price floor, or minimum expected selling price, to $3.38 per bushel, an increase of $0.38 per bushel above the $3.00 per bushel (MESP#2) established with the purchase of the $4.00 strike price put option. If prices decline from this point, the producer can expect to receive no less than $3.38 per bushel subject to basis risk.

The preceding scenario illustrates the concept of rolling up put options to raise the minimum expected selling price when the price of the underlying commodity increases over time. Taking advantage of increasing prices is an issue that agricultural producers would hope to face each year. Unfortunately for agricultural producers, when it does occur, they often fail to capitalize on the situation. The strategy of rolling up a put option conveys to the producer a minimum expected selling price at the strike price (subject only to basis risk) without forgoing future market improvements should they persist.

One final issue to keep in mind when considering this strategy involves the timing and frequency of rolling up put options to capitalize on the price increases of commodities as they occur. Since the premise of this strategy is to raise the minimum expected selling price, producers should avoid rolling up a put until the futures price of the underlying commodity increases more than the net premiums required to roll up the put options, plus the added commission and interest expenses. Otherwise, producers would simply incur additional trading expenses without effectively raising their minimum expected selling price.

An agricultural producer utilizing a put option marketing strategy typically produces the underlying commodity, but has concerns about unknown, near_term, downside market risks. The primary motivation of the producer is to protect the value of their commodities from a decrease in market price. The quantity of production covered with a put option contract is identical to those specified in the underlying futures contract. The purchase of put options is appropriate in quantities which provide downside price protection for all or a portion of a producer’s expected or insured level of production. In addition, this strategy also enables the producer to choose the most appropriate time to sell or contract their commodities. If there is a sudden and significant decrease in the market price of the underlying commodity, a put option owner, who is protected from a decline in the futures price, has the luxury of time to react.


* Assistant Professor and Extension Economist, and Extension Specialist - Risk Management, Texas Cooperative Extension, The Texas A&M University System.

 

Partial funding support has been provided by the Texas Wheat Producers Board, Texas Corn Producers Board, Texas Farm Bureau, Houston Livestock Show and Rodeo, and Cotton, Inc. - Texas State Support Committee

Produced by Agricultural Communications, The Texas A&M University System 

Extension publications can be found on the Web at: http://agpublications.tamu.edu

Educational programs of the Texas Agricultural Extension Service are open to all citizens without regard to race, color, sex, disability, religion, age or national origin. 

Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914, as amended, and June 30, 1914, in cooperation with the United States Department of Agriculture. Chester P. Fehlis, Deputy Director, Texas Agricultural Extension Service, The Texas A&M University System. 1.5M, New ECO