Risk Management 101: Part 4

Sep 26, 2023 | Uncategorized

Over the past few weeks, we’ve been learning about Risk Management (RM) from our ESP Devin Patton.

Today, let’s take a look at Options…specifically Puts.

Options can be used to hedge and manage price risk. This week we’ll talk about Puts.

A Put option is the right to be short, but not the obligation. What does that mean?

Simply, if the market price fell you would want to be short and if the market price rose higher, you would not want to be short. A Put allows for this, but it comes at a cost. The cost is known as the premium.  

For example, a guy raising corn could buy a $5.00 price Put that is for the December expiring futures contract. He would pay 37 cents/bu (5,000 bu contract) to buy it, or $1850 cash.

This way if the market drops by harvest time, he will have the right to be short December futures at $5.00, but if the market rises due to supply and demand factors, he would not be short.

Either way he still paid the 37 cents/bu, but it’s like buying price insurance for when you believe the market will go higher, and just want to be covered in case you are wrong, and it goes lower.  

When you buy a Put there is no margin required. The only risk to the trade is the cost of buying it. If the market price rises, you will not be subject to the infamous “margin call” from your broker.

As a hedger, the best-case scenario of buying a put is having the market rise dramatically. This way you capture the increase in your crop value, and only lose the premium of buying the Put. Having a side-ways to lower market means you are losing more in crop value than you are making back with your Put option hedge trade.  

Puts are the sort of trade that can work for beginner hedgers looking to manage risk in a very controlled way where the costs are completely known up front.

The problem with them is that they will not be “profitable” without a large move in price, which means your crop value has lost much more in the same market move, but they are better than having done nothing under the same circumstances. 

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