A strategy that is often used to enter the market from a fixed-risk perspective is to purchase a put option.
The buyer of a put option owns the right (not obligation) to be a seller in the futures market. Risk is fixed to the premium paid plus commission and fees.
Sometimes, however, put options can be pricey, especially when trying to buy a put that is very close to the same level (strike price) as the futures market. The opposite of buying is selling a put option, which can bring premium to a customer’s account, yet provides an unlimited risk position.
If combined with the purchase of a put option at a higher strike price, this strategy is called a bear put spread. It is used when you believe the futures market may have limited downside potential.
By selling an out-of-the money put option (strike price is below the current futures price), you are collecting the premium. This is used to directly offset the premium you are paying for your purchased option.
Why use a bear put spread? For many, it’s a combination of two reasons. One is to help offset the expense of an at-the-money put. You collect the premium on the sold put, thereby reducing your out-of-pocket costs of the purchased put.
The second reason is a belief that, while the market may go lower, the downside for declining futures price is limited.
As an example, if a farmer purchases a December $6 corn put and believes December corn futures may (at some point) get only as low as $5, he might be better off buying a $6 put and selling a $5 put. We’ll make up an example with premiums.
If the $6 put costs $0.35 and the $5 put $0.10, the net cost to the producer is $0.25. Keep in mind there will likely be additional commission.
The downfall to this strategy is if prices fall significantly below the sold put, the bear put spread has a fixed profit. One might argue the penalty for receiving premium for the sold put is incurring a fixed gain.
In the same example, if corn futures dropped to $4, the $6 put would be worth $2 in your favor (the put owner) and $1 against you (the put seller). That’s a limited gain for the spread, limited to the difference between strike prices minus commission and fees.
As with any strategy, before entering, make sure that you understand the pros and cons of the position. More importantly, understand the function of the position so it can work in conjunction with your cash marketing.
The bear put spread, while limited on its potential, offers cost savings upfront, as compared to simply buying an at-the-money put. Have a thorough discussion with your advisor on how to implement your strategy and how to place exit orders.
Editor’s Note: If you have any questions on this Perspective, feel free to contact Bryan Doherty at Total Farm Marketing: 800-334-9779.
Futures trading is not for everyone. The risk of loss in trading is substantial. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not necessarily indicative of future results.
About the Author: With the wisdom of 30 years at Total Farm Marketing and a following across the Grain Belt, Bryan Doherty is deeply passionate about his clients, their success, and long-term, fruitful relationships. As a senior market advisor and vice president of brokerage solutions, Doherty lives and breathes farm marketing. He has an in-depth understanding of the tools and markets, listens, and communicates with intent and clarity to ensure clients are comfortable with the decisions.
