Tips on Put Options for Farmers and Hedgers

05/19/2015 8:00 am EST

Focus: OPTIONS

Sherwood Tucker, of IASG, Inc., highlights the pluses and minuses of buying a put option as opposed to buying a call option, the steps for an options trader to take, as well as a few pertinent points about time decay and Delta to also consider.

A basic option strategy to be familiar with and learn the advantages and disadvantages of is buying a put option (long put).  Buying a put option is the opposite of buying a call option, in that a put gives you the right, but not the obligation to sell the underlying futures contract at a specific strike price.  When you buy or go long a put your outlook is bearish the market and you expect a fall in the underlying asset price.

Steps to Trading a Long Put

  1. Buy or Go Long the Put Option
  • Remember that for futures option contracts in the US, one contract is for one futures contract.  So when you see a price of .20 cents for a put option for corn, you will have to pay $1000 for that option. (.20 cents x 5000 bushels = $1000), plus any commissions or fees.

  1. A Few Points to Consider:
  • If you feel prices may go higher but you need to protect your cash grain or livestock against a decline in prices, and using no margin, then a put option is probably the way to go. The reason being is three-fold.  If you do buy a put and prices do in fact go higher, then your put option will lose value. However, because the price has gone higher, you will be able to make and lock-in higher priced cash sales, which should more than offset any premium you invested in the put option(s).  Second, if you buy put options and prices do decline, you are protected on your (ex: grain / livestock), at the put’s strike price minus the premium you paid.  Third, again, if prices do decline, you are protected as mentioned above but you will be able to hold onto your (ex: grain / livestock), knowing what price you have locked-in and ride it out. If the market does in fact bottom and head higher you will be making cash sales at higher prices and you were able to sleep at night knowing you didn’t have to panic and make cash sales at lower prices. Plus you were not using margin to do this, so your risk is limited and a known factor.

  • Buying a put is a net debit transaction, because you are paying for the put.  Your maximum risk is capped to the price you pay for the put and your maximum reward is uncapped until the underlying falls to zero.

  • Time decay works against your bought / long put option. Give yourself plenty of time.  Don’t be fooled into a false sense of security of thinking that buying shorter-term, cheaper options are better.  Compare a one month option to a 12-month option and divide the longer-term option price by 12. You will see that you are paying far less per month for the 12-month option.

  1. Advantages and Disadvantages

Advantages

  • Protect or profit from a decline in the underlying price of the asset.

  • Uncapped protection or profit potential with capped risk.

Disadvantages

  • A potential 100% loss of the premium paid.

  • An option will not trade 1-for-1 with the underlying. Depending on what put option you buy, let’s say that the underlying asset makes a price move of $1.00, your put option may only move .70 cents, depending on the Delta*.

*Definition of Delta—Movement of the option price relative to the movement of the underlying asset (futures contract). A Delta is a numerical number (ex:  0.52) which gives us an indication of the speed at which the option price is moving relative to the underlying asset (futures). Therefore a Delta of 1 means the option price is moving 1 point for every 1 point the futures price is moving. Typically, an at-the-money option has a Delta of 0.50 for calls and -0.50 for puts, meaning that at-the-money options half a point for every 1 point move in the futures contract. Delta is another way of expressing the probability of an option expiring in-the-money or ITM.

By Sherwood Tucker of IASG.com

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