Options trading is one of the ways that producers and speculators can engage the grain markets. In contrast to buying or selling futures contracts in the corn market and wheat market, options provide a collection of exclusive opportunities. If you’re interested in becoming active in the grain market complex, then options are certainly worth a look.
Grain Options vs. Grain Futures
When it comes to hedging risk in the corn market and wheat market, futures and options contracts are indispensable parts of doing business. However, although each is technically classified as a derivatives product, their respective functionalities are very different. Here are a few key distinctions that make grain futures and grain options unique securities:
- Commitment: One of the primary differences between futures and options is the degree of commitment. A futures contract binds participants to the stated terms of settlement, while options furnish the holder with a no-obligation right to buy or sell at a forthcoming point in time. This is a major consideration because financially settled options contracts preserve the individual’s liquidity.
- Pricing: Although both grain futures and options are subject to the same pricing mechanism of the underlying asset, P&Ls are tallied very differently. For futures, profits and losses in the corn market and wheat market evolve on a tick-by-tick basis. This is also true for options, with contracts being either “in-the-money” or “out-of-the-money.” However, the impact on P&L is very different due to the pricing of the entire options chain in relation to the contract’s strike price.
- Risk: Assuming the lack of any risk management parameters, buying or selling futures contracts outright exposes the trader to potentially unlimited financial liability. In contrast, options offer a fully quantified risk, with the only capital in harm’s way being the premium paid for the contract itself.
Perhaps the largest difference between futures and options is the degree of flexibility. While it’s certainly true that futures offer countless trading possibilities, options may be used in an even broader sense. Featuring limited up-front liabilities and cash settlement, grain options provide hedgers or speculators with opportunities simply not available in grain futures ― one of which is the straddle strategy.
Using the Straddle to Hedge Risk
If nothing else, the first half of 2019 has reinforced the importance of hedging for grain market producers. The catastrophic Midwestern flooding of March, April, and May brought widespread destruction to grain stores as well as a delay to the planting season. Production fallout was significant, leading to a spike in grain and oilseed prices.
For many farmers, buying futures contracts in the corn market or wheat market is a standard part of doing business. The long futures position protects crops against disaster and are frequently used to forego the risk of lagging spot market prices come harvest time. However, such strategies can be expensive and are not foolproof. When it comes to limiting the risks associated with the unexpected, implementing a straddle strategy is often a preferred course of action.
A straddle involves the buying of both a put and call option for the same product, at an identical strike price and expiration date. By doing this, a producer or trader enjoys two advantages especially useful in risk management:
- Unlimited profit potential: By using a straddle, profits are realized as current market price deviates from the contract’s strike price. Theoretically, profit potential is unlimited. In the case of unforeseen disasters or events, straddles can produce extraordinary returns as market prices behave erratically.
- Quantified risk: The only capital being risked in a straddle is the premium paid for the options contracts themselves. This is an important element of hedging, as unchecked assumed liabilities can prove costly.
Due to the flexibility of options, grain market speculators and hedgers alike frequently use straddles. They position participants to profit from rising or falling prices simultaneously, while adhering to a predetermined risk.
Although standard futures in the corn market and wheat market are an attractive way to address many of the downsides facing those two commodities, they do feature limitations not local to options. For many, the straddle and other options strategies are ideal ways of preserving hard-earned market share.
Getting Started with Options
At first, the ins and outs of options can be a bit intimidating. The concepts of buying and selling calls or puts appear abstract. Before jumping into the options markets, it’s imperative to have a firm grasp on the fundamentals.
