Today’s Number: Hedging the New Crop in the Short Term

 

There’s good news – for most of the eastern corn belts the drought is over. Then there’s bad news – the recent rains that have replenished soil moisture have delayed planting to what might soon be historically the slowest rate ever. I recall hearing a prominent grain market analyst speak last winter. In his comments he suggested corn could be $4.00 this year or it could be $9.00 this year, depending on the growing season. Now, in late April, we don’t have a solid idea as to which of these prices will come to fruition.

Options were introduced in 1984 as a lower cost, more flexible way than futures to approach these kind of issues. We all quickly learned that time to maturity and volatility were the primary driver of options premiums. Because of the long time between when we plant the crop in Spring and when options on December futures expire in November, the cost of hedging with options could be substantial. But for many the benefit of protection at a fixed price with the opportunity to participate if the market moves favorably still had significant appeal.

Last year, we introduced the next natural evolution to help market participants have more flexibility and lower cost solutions to managing risk in the form of short dated new crop options (SDNCO).  SDNCOs give producers the opportunity to hedge with a lower cost than the traditional options contracts but for a shorter period of time. For example, there are corn SDNCOs available expiring in April, June and August which, if exercised, allow you to establish a futures hedge in the December futures. These shorter maturities mean less time value and lower options premium than standard options.

The tradeoff is that with a shorter maturity, your protection doesn’t last as long. You might need to buy additional options if marketing uncertainly continues to exist after your initial options expire and if you haven’t sold the grain you are hedging. This is a tradeoff that many customers are willing to make. Open interest in SDNCOs reached a record of more than 140,000 contracts prior to the expiry of the May 2013 options at the end of April.

Historically, you love the idea of options if you’re a trader. If the market doesn’t go your way, you have protection. But time increases the cost of options. With the events we’ve seen so far this year, SDNCOs are proving to be at least one part of the solution for a lot of ag market participants.

Tim Andriesen is Managing Director of agricultural and alternative investment products at CME Group.

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