Protect Annual Income with the Option of Options
As we near the end of the 2017 season, many farmers are worried about their crop yields coming up short. While the actual product is at the mercy of Mother Nature, a sound hedging strategy using options rather than only futures is a great way to protect a farmer’s business against unexpected market exposure . Hedging with options allows an investor to protect against the downside while potentially leaving opportunity to make money on the upside, all at a lower initial investment than outright futures.
Hedging with futures can be a viable strategy, but it also places a strain on the finances of the farm, which is the opposite intention of a hedging strategy. Futures can cost thousands in margin per contract, which means the investor will have to have at least that amount in their account. If the market slides against the farmer, they might have to continually pull money over from their cash business to maintain the hedge.
Should the farmer want to adjust a hedge position, they potentially may have to add money to a losing position. This means the investor is not making money while supporting the hedge on the chance that it turns around, which can be a painful drain on resources. Because of the initial expense and the unknown total costs, most farmers avoid hedging altogether without even considering the possibility of options.
If a farmer expects a certain amount of crop, they may need to sell at a specific price to turn a profit. If the harvest is projected to have a low yield, it may be necessary to take advantage of rising prices. For example, call strategies are implemented to take advantage of a market that is trending up. This will show a profit on the farmer’s side to offset the obligation they can’t fulfill with a weak harvest. The farmer will have to buy more crop at some point, which will be easier if they have a long hedge in place.
Most successful hedging strategies will need to be adjusted throughout the season, depending on a number of variables. (e.g. weather, market movements, forecasted yield, time etc.) The beauty of adding options into a hedging strategy is that a well managed position created with options can leave opportunity to capitalize on market movements in either direction. There is a cost associated with initiating and holding the hedge, but it can often be significantly less than hedging with only futures, if done correctly. Additionally, the price of hedging with long options is defined up front, effectively eliminating the unknown drain of capital with an only futures hedge.
While it is possible to profit off hedging, the overall goal should be to stabilize risk. Placing strategies in motion without creating financial stress will be a huge boon to the health of the farm. There are specific strategies that are executed for farmers, but remember that hedging with options is not a one-size-fits-all process. It will depend on timing, individual risk tolerance and many other factors, as prices are always moving. Each year presents its own set of unique risks, so working with a professional to create a tailored hedging strategy can offer the greatest risk protection.
About Howard Marella
Howard Marella was on the front lines of the trading floor at 21 years old eventually earning his registration as a floor member at the CBOT and CME. Through the extensive experience he received on the floor, Howard hand-picked his own team and began his own business. In 2006, he launched Marella Capital Corporation which stood strong the the economy’s toughest tests, and it eventually flourished into what is now known as a leading, forward-thinking futures investment company, Icon Alternatives.
About Icon Alternatives
Icon Alternatives is a Chicago-based, forward-thinking alternative investment firm that specializes in futures contracts. Their experience has deep roots reaching back to the golden age of floor trading in the ‘80s to acting as committee heads for the CME in the last decade of Index Futures Group. Icon Alternatives remains ahead of the curve to provide investors true portfolio diversification as investment theory continues to change.