We recently had the privilege of co-presenting with the CME Group at their CBOT Grain Options Workshop during the annual Wild Oats Grainworld conference in Winnipeg. Here’s an overview of that event including what is risk, what is risk management and a straightforward strategy you can use to protect yourself against falling grain prices.
What is risk?
For us, risk is not standard deviation, volatility or even losing some money. The definition of risk that most connects with clients is the consequence of not meeting your objectives. We like to work with clients to define internal benchmarks and levels that take into account their exposure, revenues, costs, break-even and even their worst-case scenario.
Risk, like energy, cannot be destroyed but it can be altered, redirected or transferred. Risk management is not about not losing any money, it’s about balancing risks and balancing gains and losses.
Risk management doesn’t just necessarily manage the risks of the markets; it manages the risk of the behaviour of the individuals who make up the markets. This gets into the realm of psychology, or the new fancy term “behavioural economics,” also known as human nature.
What is risk management?
We are all learning every day in the markets and we want clients to learn more about their money so they can earn more on their money. A risk-management strategy needs to start with learning and education. Once you are comfortable and confident with the basics, a proactive, disciplined, straightforward risk-management strategy can be developed.
- Proactive: As Benjamin Franklin said: “By failing to prepare, you are preparing to fail.” We want to plan ahead while remaining flexible, ready to act and adjust strategies over time as markets develop and opportunities present themselves.
- Disciplined: I find the best methods don’t attempt to guess where prices are going but rather consistently apply predefined risk-management techniques. The aim is not that it works perfectly every time, but rather consistently over time.
- Straightforward: Simple, straightforward strategies provide the greatest results since you are more likely to use them. There’s no point building a more complex mousetrap if no one is going to use it.
Protecting the downside
A protective put option strategy is very straightforward. It’s just like buying price insurance on future production or grain sitting in the bin. It is simple but can be costly because of the premium you pay, but there can be good reasons for this type of approach when prices are high.
Here’s a recent example of a producer north of Winnipeg who wants to hedge his new-crop soybeans for October/November delivery. He is very profitable above $12/bushel so with November soybeans currently at $12.65, we decided to buy November $12.40 put options. In other words, he can sell a futures contract at $12.40 even if the market has dropped below that level. The options cost $0.60, which means he’s established a floor price of $11.80. The main benefits of this approach are downside protection with upside potential.
From now until November, soybeans can move either up, down or sideways. Let’s look at each scenario:
- Up: Soybeans reach $15 for Oct./Nov. Since that is above $12.40, the put options expire with no value, but the farmer can sell grain into the cash market at $15. He’s lost the put cost of $0.60, but still nets $14.40, less local basis.
- Down: Soybeans drop to $10 for Oct./Nov. The options purchased at $0.60 are now worth $2.40 — the difference between the $12.40 put strike price and the current price of November soybeans at $10 — for a net gain of $1.80. The farmer sells into the cash market at $10, or a net price of $11.80 minus the basis.
- Sideways: Soybeans are at $12.65 for Oct./Nov. The $0.60 options expire with no value, but the farmer sells in the cash market at $12.65 for a net of $12.05 minus the basis.
This protective put strategy offers:
- Downside protection below $11.80/bu. less basis. (Put strike price of $12.40 minus premium of $0.60 = $11.80.)
- Upside potential above $11.80/bu. (Put strike price of $12.40 minus premium of $0.60 = $11.80.)
Overall, for the cost of the insurance premium to protect the downside, you can also participate in upside of higher prices.
The bottom line, like everything in the markets, is that you have to balance risk and reward. Some strategies cost very little so offer less protection and with little upside. Others are more expensive but give full protection and more upside.
It’s important to remember that this is just one of many strategies. You shouldn’t hedge everything with one strategy at one time. Instead give yourself some flexibility to diversify your hedges. While you won’t be right every time with your market direction or strategy, what is plausible is a consistent, disciplined approach year in, year out to help you manage your risks before they manage you.