There are many risk management strategies for price protection during uncertain markets. These strategies can be helpful for grain and oilseed buyers, such as grain processors, feed manufacturers and food companies.
There are times, however, when buyers expect the market to remain relatively stable. In this type of scenario, rather than looking for protection against a possible price increase, buyers may instead seek ways to lower their purchase price.
This module will describe how grain buyers can sell put options as a strategy for potentially paying a lower net price for the grain they need.
Assume that it is August and a wheat buyer for a food company plans to purchase wheat in mid-November. The December wheat futures price is currently $4.40 a bushel.
The wheat buyer is comfortable with this price, because he knows that his company’s food business will be profitable if he pays $4.40 for wheat. But, if possible, he would still like to find a way to lower his purchase price further.
One way to do this is by selling wheat put options. As the option seller, he would collect a premium upfront from the option buyer. He could potentially lower the net price of the wheat he purchases by the amount of the premium he receives.
The wheat buyer decides to sell an out-of-the-money December Wheat put option with a strike price of $4.30, for which he receive an 8-cent premium.
By doing this, he establishes a minimum net purchase price of $4.22 a bushel, which equals: the $4.30 option strike price minus the 8-cent premium.
Again, the goal of this strategy is for the wheat buyer to be able to retain the premium he received from selling the put option, which he can then deduct from his net purchase price.
In order for this to happen, the wheat market must remain relatively stable.
The futures price should not increase higher than $4.48, which is the current futures price of $4.40 plus the 8-cent premium he received.
For example, suppose wheat increases to $4.55 per bushel. The wheat buyer’s effective purchase price would be $4.47, which is the futures price minus the 8-cent premium he received.
As long as the futures price stays above the put option strike price, the put option is not likely to be exercised; the holder of that put option will not want to exercise an option to sell wheat at $4.30 a bushel if he can get a higher price for it in the cash market.
However, keep in mind that the wheat buyer’s goal is to purchase wheat at a lower price than the current market of $4.40.
If wheat prices actually do increase, his protection against higher prices will be limited to the 8-cent premium he received for the put option.
For instance, what if December wheat futures increase to $4.70 a bushel? The wheat buyer will retain the 8 cents he received for the $4.30 put option since it will not be exercised, but he will pay a higher price for his wheat than the $4.40 he was initially facing.
His effective purchase price will actually be $4.62, which is the futures price minus the 8-cent premium. So, selling the put option gave him some protection against higher prices, but only to the extent of the 8-cent premium he received.
Remember that the wheat buyer essentially established a minimum or “floor” purchase price for his wheat by selling the put option, which he will reach if the futures price drops below $4.22: the $4.30 strike price minus the 8-cent premium.
The put option obligates him to buy wheat futures at $4.30 even when wheat is priced lower in the market.
If December Wheat futures were to fall to, say, $3.50 per bushel, the put option will be exercised, requiring the wheat buyer to purchase wheat futures at the $4.30 strike price, even though they are only priced at $3.50 in the market.
While this is lower than the $4.40 he expected to pay for his wheat before he initiated the hedge, it did not allow him to take full advantage of lower prices in the wheat market.
In summary, selling put options can be a way for a long hedger to lower their purchase price, but it is not without its risks. Again, the effectiveness of this strategy is contingent upon market prices remaining relatively stable.