When $7 = $4.80

Beware the hidden risks!

Margin call risk can be sizable, but at least it’s easy to identify and quantify. Beware of the hidden risks of some contract strategies involving options that can explode suddenly into serious losses during big market swings (up or down):

1. “Reduced-cost” minimum price contracts

a. farmer sells priced grain to the elevator

b. the elevator offers upside price potential by buying one or more call options and tying the subsequent value of the options to the contract

c. the elevator sells out of the money put options and collects a premium which is used to reduce the cost of the call(s).

2. “Ratio” minimum price contracts

a. farmer sells priced grain to the elevator

b. the elevator offers upside price potential by buying one or more call options and tying the value of the options to the contract

c. the elevator sells higher Strike Price call options at a ratio of 2:1 or more, and collects multiple premiums which are used to reduce the cost of the call options that were purchased in (b).

3. Premium-Offer contracts (or similar names)

a. farmer sells priced grain to the elevator

b. the elevator sells one or more call options at Strike Prices above the market and credits the premium collected over to the farmer,

c. and requires the producer to sell more bushels to the elevator if the designated futures contract price is at or above the Strike Price on a specified date.

Each strategy has special risks in certain market conditions. In #1, the risks develop if futures fall hard and the short put options are exercised. That leaves the elevator long futures with nothing to offset them unless the contract clearly states the farmer would be responsible for such losses.

In #2, the risk lies in rising prices. As futures climb, the elevator is losing money on two (or more) short call options while making money on only one (the lower Strike Price). The higher futures rise the worse the outcome. Again, unless the contract clearly states the farmer would be responsible for such losses, the elevator will have a major problem on its hands. There is also the problem that although a futures rise will ‘hurt’ the position, the final outcome can’t be identified until either option expiration or until the option positions are exited.

In #3, the farmer faces an even bigger uncertainty. This strategy creates a binding obligation that the farmer will sell additional bushels to the elevator, but contingent only if futures are above a specific price on a specific date. There will be no additional obligation to the farmer if futures are below the designated threshold on the specified date. The benefit for the farmer of this strategy is that he or she collected some premium/incentive at the time of the original contract — a “signing bonus,” as it were.

Strategies 2 and 3 can be major problems in bull markets such as 2010/2011. The farmer starts off at what is an attractive selling price and gets a “bonus” premium added on top of the price! Example:

July 2010: Dec 2011 corn futures around $4.40Dec 2011 $4.80 corn calls were trading around 30¢/bushel