Options can offer ways to better manage risk with flexibility and capital efficiency.
In addition to traditional options, which you are probably familiar with, there are also short-term options. Short-term options are established, liquid products with streaming electronic quotes. They are also very active, trading nearly two million contracts a year. But the biggest benefit is that short-term options can save you money; because one of the main factors in option premium is time. The longer time frame an option covers, the more expensive the option premium.
If you can define your risk time horizon in the shortest time frame, you should see a savings in options premium. For instance, imagine being able to buy flood insurance just during rainy months, instead of year-round coverage. This is similar to the concept of short term options.
In agriculture, there are periods of heightened risk that can move the markets, such as weather risk during the growing season or events like the monthly WASDE report.
A producer can use short-term options to define the specific window for which they would like coverage and because of the shorter time frame, the option cost is lower.
CME Group offers two types of short-term options: weekly options and short-dated new crop options.
Weekly options expire every Friday in benchmark agricultural products that do not have a standard option already expiring and are based on the front month contract. Weekly options can help you hedge around high impact events, such as the USDA report, or manage short term exposure to the market.
Say you have hedged your cash position with futures. You still would like to participate on any upside move that is driven directly from the USDA Acreage number.
You could purchase a weekly at-the-money call for a couple of cents. If the USDA Acreage report causes prices to dramatically spike, the call will increase in value And you will benefit from the increase in price. And, you are still fully hedged with the futures position.
The time duration is what makes the weekly option effective. You can participate through the USDA Acreage report number, with defined risk, in a cost-effective manner.
The other type of short-term option is a short-dated new crop options, which are based on a long-dated future, but the option itself has a short time frame.
It is important to keep in mind that for a hedge to be effective it must be tied to the proper instrument; and there is a fundamental difference between old crop and new crop futures.
If your risk is tied to new crop, you want an option that reflects that. In the past, you had to purchase a long-dated option tied to the corresponding new crop.
But with the advent of short-dated new crop options, you can purchase an option contract that has the proper longer-dated underlying future, while the option itself has a shorter time horizon. That shorter time frame means cheaper option premiums.
Say it is June, and you are a soybean producer. The weather and increased yields have you concerned about a downward move in new crop prices.
You have two choices for options: purchase a put option in the November contract or purchase a September SDNC option.
Historically, SDNC options premiums were 30% cheaper compared to a standard November options. Since you are not too worried about your crops' exposure to mother nature later in the summer and you feel prices will be mostly set, you could opt for coverage through August instead of October. That means you will pay less in option premium.
After all, why pay for more coverage than you need? Short-term options are liquid, established and they can help better manage your risk at a lower cost. For more information visit www.cmegroup.com/agoptions.