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Put Options - a forward contracting alternative

Tragically, the season has not continued the way it started and the market consequences have been severe. The poor season in Australia has followed poor crops and difficult harvests in the Northern Hemisphere. The global supply and demand equation for wheat is very tight. As a result, prices are trading at record levels and market activity has been volatile.

To add salt to the wound, many growers with forward contracts have had to “wash out” contracts because of crop failure. When a contract is "washed out" it is bought back at the prevailing market price. Regardless of whether the forward contract is physically delivered or cash settled, the seller has a forward commitment and a risk if the underlying crop fails. The cost of getting out of the contract is unknown at the time of contracting.

Is there a way to manage price risk as well as production risk?

Growers can look to protect their business from falling commodity prices without any production obligation. This is achieved by essentially insuring the price of the commodity against a market downturn. Buying a put option achieves such a trading strategy.

A Put Option refers to the right to sell a futures contract at a certain price on or before a certain time in the future. When you put your ute on the market – you are trying to sell it. When you buy a Put option you are buying the right to sell the futures contract.

Similar to insurance, you are buying a right, not an obligation. When you insure your car, you reserve the right but not the obligation to have an accident in the next twelve months. When you buy a put option you reserve the right, not the obligation, to sell at a certain price. Importantly, because you are buying a right, you are protecting the value of your crop but if market prices trade higher you are free to take advantage of better prices.

When you buy the put option, like insurance, you pay what is called a premium. The premium is what the strategy costs, so you know the money you are putting at risk. If you suffer crop failure, you have no obligation to the market. You can either look to sell back the bought option in the market or let it lapse worthless or exercise if it is in the money at expiry. 

On the 26th April 2007, the January 2008 Milling Wheat 235 Put Option traded at $26. That is, the buyer of the put option reserved the right to sell January 2008 Milling Wheat at $235 NSW track. The cost of this option was $26 per tonne. On its own, $26 per tonne sounds like an expensive investment. However, we need to look at what this strategy achieved.

Firstly, had the market traded lower, the floor price would have been $209 NSW track. The floor price is calculated by taking the cost of the option (the premium) $26 away from the reserved sale price (exercise or strike price) $235.

As we now know, the market traded higher and the most this strategy cost was the premium paid of $26. The option buyer is free to sell wheat at the higher market price. On Wednesday 26th September 2007, January 2008 Milling Wheat settled at $450. Allowing for the cost of the option, the option buyer could possibly realise $424 ($450-$26) NSW track for the wheat.

As you can see, what originally looked like an expensive strategy achieved a satisfactory return if prices fell but also allowed the grower to participate in market upside. All of this was achieved with a limited investment risk. Had there been crop failure, the risk was known at $26 per tonne.

ASX Contract 26th April 2007 26th Sept 2007 Hedge Return
(AUD/tonne)
Final Result
Futures Hedge Sell Futures Buy Futures
AWM8F $239 $450 -$211
($239-$450)
If there is a crop sold the final result will be $211 lower than the actual price sold at. This highlights the risk involved in selling forward.
Put Option Hedge Buy Options Option Worth
AWM8F
235 Put
$26 $0
If price fell     $209
($235 - $26)

If prices fell, the floor price established equaled $209 NSW Track. This price is calculated by taking the premium paid ($26) away from the reserved sale price ($235).

Price rose   $450 $424
($450 - $26)
The right to sell at $235 would not be exercised. Instead, the grower is free to sell wheat at the prevailing market price. Using $450 as the price achieved, the final result would be $424 = $450 less $26, the cost of the option.
If there was production failure -$26 The risk of this strategy was always known as the cost of the premium paid. Unlike selling forward, the cost of the "washout" was always known to be no more than the $26 per tonne premium paid for the $235 Put Option. 

Put options are available over the following ASX contracts; Milling Wheat, Feed Barley, Canola and Sorghum.

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