Putting volatility to work

Putting volatility to work

From options to insurance, fear can create opportunity and raise costs

Big swings in prices, both up and down, are a fact of life for corn growers. This volatility can be frustrating — and not just because it makes market moves so hard to predict. Volatility is a double-edged sword. It not only provides opportunities for farmers, but also can raise the cost of everything from options to insurance.

When prices are rising, say on a weather scare during the summer, panicky buyers and greedy speculators can drive prices irrationally higher. That can bring a windfall for growers with inventory to sell, or those who can block out the noise and forward-price crops that haven’t been harvested yet.

Volatility provides corn farmers the opportunity to capture higher prices, but brings along added risk.

Buying put options that convey the right to sell futures is one way to take advantage of higher prices. But the cost of these puts may increase when anxiety heats up along with the thermometer. Those who write, or sell, these options demand larger premiums because they face more uncertainty and potential for losses. Of course, farmers can sell these options too, and pocket the premium — if they can stomach the margin calls that come with losing positions.

There are complex mathematical formulas for evaluating this risk that compare options premiums to the price of their underlying futures. This is known as implied volatility, because it is based on what traders assess for the future.

Putting volatility to work

Indexes of this volatility are put out by the CME Group, home of the Chicago Board of Trade. There are numerous indexes, but the most famous one is for the S&P 500 futures contract. The VIX is also known as the “fear factor,” because volatility in the stock market tends to peak when prices are plummeting on Wall Street.

Stock investors don’t fear rising prices, so volatility tends to subside in bull markets. Just the opposite is true for volatility in the grain market. While it can rise when prices fall sharply, most of the big moves in volatility occur when prices are shooting higher.

When corn prices are sluggish, volatility tends to be lower. Boring markets, especially when they’re at unprofitable levels, may provide fewer opportunities for pricing crops. But they can be useful nonetheless.

Corn basis in the cash market strengthened after harvest in 2015, even as futures stagnated. Volatility was relatively low, making it easier for growers to sell cash corn and buy call options to keep some upside open.

Options cost more during times of uncertainty because they’re a form of insurance. As a result, implied volatility is part of the calculations used to determine crop insurance premiums.

For corn growers, base prices for insurance are set on the average of December futures during February. Premiums figure in volatility of December corn options during the last five days of that month. Higher volatility means growers pay more for their insurance.

These policies could be a little cheaper for 2016 if markets stay flat this winter. Implied volatility in December for new crop futures was at its lowest level since the big surge higher during the commodity boom-and-bust of 2008-09.

Crop insurance premiums benefit from a government subsidy, so the policies are hard to beat as a risk management tool. Growers who want additional coverage from the market could get a break this year, too. Those who want to buy out-of-the-money call options to make it easier to sell this spring and summer should find the cost of those positions costs less, too.

That’s another reason not to go to sleep during boring markets.

- Knorr is senior grain market analyst for Farm Futures.


Decision Time: Risk Management is independently produced by Farm Futures and brought to you through the support of Case IH. For more information, visit farmfutures.com/decisiontime

Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish