farmgate: So, You Think Put and Call Options Are Too Expensive To Buy? The Jury Just Returned Its Verdict!
Do you use put and call options as part of your marketing risk management strategy? Oh, you don’t! And why not? The premiums are too expensive, you say. And why do you think that? Well, the combination of Rick Brock, your lender, your brother-in-law, and the coffee shop consensus would tend to tip the scale, particularly if your lender lined up against options. Would you reconsider if some researched-based information were offered? Well in that case, read on…
The Chicago Board of Trade certainly recognizes that farmers make up a small portion of their clientele which use the options pits, because of the cost to ante up. Its publication, “Establishing a Selling Price Range for Corn and Soybeans” acknowledges the cost and warns, “When evaluating price risk management strategies, some producers may shy away from options because they feel the option premiums are too costly.” Because of the lack of research on the issue ag economists Hernan Urcola and Scott Irwin at the University of Illinois studied your contention. They say, “If option premiums are too high, farmers that hedge the value of their crops or grain processors who hedge input purchases may lose substantial amounts of money when using options. It is the equivalent of buying expensive insurance, and if this insurance is expensive enough, the cost can offset (or more than offset) the benefits of reducing risks.” They wanted to test the efficiency of the corn and soybean options market by directly computing returns on trading options.
Just so everyone understands the put and call option relationship, in the case of a put option, a long position in the market will earn money when the underlying futures price drops. In the case of a call option, a long position in the market will lose money when the underlying futures prices drops. If that futures price increases, the call will earn money and the put option will lose money. When long positions make money, short positions lose money, and vice versa.
The researchers looked at the past 15 years in the options market for corn and soybeans and determined there were no strong trends that occurred other than noting a high corn price in June 1996 and high corn and soybean prices in March 2004. Average trading volume increases as the option gets closer to maturity, and increases more for beans than corn. The heaviest trading occurs when the strike prices approaches 1. Trading volume is higher for Out of the Money options than In the Money options; and for both corn and soybeans, Out of the Money calls are more heavily traded than Out of the Money puts.
Urcola and Irwin found that option returns increase as the option is more Out of the Money. For example, At the Money calls expired worthless 73% of the time, while In the Money soybean puts expired worthless 23% of the time. That means the buyer of an At the Money or Out of the Money option usually loses his premium, but may have obtained a large gain. But can investors in option premiums go in with an expectation of making money? Urcola and Irwin say no. “This indicates that investors can not rule out, with 95% confidence, a zero return when trading these options. In other words, it is not possible to rule out that the true mean of the return distribution is zero for most of the options. Given the results presented, it is unlikely that investors would be able to make profits by taking either side of the corn and soybeans options market.” And they continue, “For the two markets (corn and soybeans) analyzed here, results suggest that no gross mispricing exists for corn and soybean options.”
When the researchers looked at the first half of the 15 year span, they said the spike in corn futures in June 1996 caused call option returns to be positive and put option returns to be negative from 1991 through 1997. In the more recent period corn prices declined causing negative returns for calls and positive returns for holders of put options. In the same period, soybean futures climbed above $10, making call option returns positive.
When Urcola and Irwin split the 15 year span into two halves, they said, “Corn calls appear to have provided excess returns during the 1998–2005 period. These results do not appear to be driven by movements in the underlying futures, since similar differences were not found for corn puts. Results indicate that soybean options (both puts and calls) would constitute fairly-well priced insurance tools.”
Summary:
While the technical mathematics in the Urcola and Irwin study have been eliminated from this summary of their research, they have agreed with farmers to the extent that call options may have been overpriced in the past seven years, when they say the options provided “excess returns.” However, the put option, which provides the basic risk management tool against price declines, was found to be fairly priced for both corn and soybeans. A significant part of their research relied upon the expectations of option traders making money with a 95% or higher confidence level. When they found that was not possible, the conclusion was that the premiums were fairly priced.
Posted by Stu Ellis on September 25, 2006 5:18 AM to farmgate