Marketing 101: Knowing the tools in your marketing toolbox and when to use them

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1 Marketing 101: Knowing the tools in your marketing toolbox and when to use them Brian Grete Sr. Market Analyst, Pro Farmer

2 Hedger or Cash-Only Marketer? comparing the two Cash-only marketers Fewer tools in the tool box Cash sales Forward-contracts HTAs Minimum Price Contract Basis contracts Doing nothing Less flexibility Hedgers More tools in the tool box All tools of the cashonly marketer, plus: Futures Long and Short Options Calls Puts More flexibility

3 Defining the Tools: Cash sale (spot market): Selling a commodity at the local elevator, ethanol plant, etc. for immediate delivery. Cash forward contract: Contract to make a cash sale for future delivery of a commodity. Basis contract: Contract that locks in the basis, but not the (futures) price. Sell cash and buy futures: Making a cash sale and reowning the commodity in a long futures position. Sell cash and buy call option: Making a cash sale and reowning the commodity in a long call option position. Minimum price contract: Contract that locks in a minimum price at an elevator and keeps upside potential open (for a fee). Offensive price hedge: True hedge that you will maintain. Locks in a profitable price.

4 Defining the Tools: Defensive price hedge: Hedge when the price is not profitable (or attractive), but market conditions signal lower prices. Hedge-to-arrive contract: Contract with an elevator that locks in the price, but not basis. Transfers basis risk to the producer. Purchase of put option: An option that gives the buyer the right, but not the obligation to go short the underlying futures contract at the strike price on or before expiration. Deferred price contract: Contract that provides the producer the opportunity to deliver a commodity (and transfer ownership) on the contract date without setting a sales price. The courage call option purchase: Buying an out-of-the-money call option that gives you the courage to make a cash sale when futures reach the strike price. Writing covered calls: Selling (writing) a call option that covers or helps pay for the cost of a long position in a commodity. Doing nothing at all: A decision to wait on a better price and/or basis before making a cash sale or taking a position on the board.

5 Risk level: 100% Cash-only marketers and hedgers normally have 100% price risk on their crop! Cash-only marketers After forward-pricing 10% of a crop, you are left with 90% downside price risk and 10% upside price risk (opportunity risk). Opportunity risk can be minimized with a Minimum Price Contract or HTA. Each erases downside risk on crop sold. Minimum price gives opportunity for price appreciation; HTA give opportunity for basis appreciation. Hedgers After forward-pricing 10% of a crop, hedgers are left with 90% downside price risk and 10% upside price risk (opportunity risk). The opportunity risk can be reduced with long call option or buyback in futures. Downside risk can be reduced with cash sales, short futures (hedges) or long put option. Futures and options positions can be adjusted to appropriate risk level. The key is to balance downside and upside price risk based on market conditions.

6 Things we hear... Cash-only marketers I won t sell any new-crop corn until the crop pollinates... How can you sell something you don t know you ll have? This marketer maintains 100% downside price risk (and upside potential) on new-crop corn until pollination. Hedgers I always have at least half my new-crop corn sold, or hedged, by pollination. This marketer has 50% downside price risk and 50% opportunity risk... That s well-balanced risk at a critical time in the crop s development. Which grower is more conservative? Which is more aggressive?

7 Things we hear... Cash-only marketer I won t sell anything until it s in the bin! This grower maintains 100% downside price risk through harvest. (Grower also has 0% opportunity risk.) Hedger I hedge 100% of my expected crop before the last kernel goes in the ground and then I ll buy calls or futures if a crop problem develops. This grower erases all downside price risk during, or before, planting and has 100% opportunity risk. These are the two extremes of marketing: One is very aggressive and carries 100% downside price risk through harvest, the other is very conservative.

8 Things we hear... Cash-only marketer I refuse to speculate in the grain markets. Hedger I refuse to speculate in the grain markets. Grain in the bin is speculation prices will rise; cash grain sales are speculation prices will fall. (However, add in knowledge and a plan and this speculation becomes marketing. ) Grain in the bin might be hedged and grain sold in the cash market might be bought back in futures or call options. (Hedgers become speculators when they Texas Hedge either long or short.)

9 Which is more conservative? Cash-only can be conservative -- and hedgers can be aggressive Just keep downside price risk balanced with opportunity risk to match market conditions

10 Know your market conditions Poor Basis/ Bearish Price Outlook Poor Basis/ Bullish Price Outlook Good Basis/ Bearish Price Outlook Good Basis/ Bullish Price Outlook

11 Tools to use with poor basis Offensive hedge in futures market Defensive hedge in futures market Hedge-to-arrive contract Purchase of put option Deferred price contract Doing nothing at all

12 Tools to use with poor basis And a BEARISH BIAS for futures

13 Offensive ( true ) hedge in Conditions: futures market 1) Unusually profitable price level or price target hit 2) You re prepared to leave it on no matter what 3) You believe the downmove is either imminent or already underway

14 Defensive ( selective ) hedge Conditions in futures 1) Price is shy of target, but futures look toppy 2) You will abandon the hedge if sell signal is negated 3) Stop placement leaves a 3:1 reward:risk ratio

15 Hedge-to-arrive contract Conditions 1) Meets conditions of offensive hedge, but you are not in a position to meet margin calls 2) There is little or no risk of unusual basis distortions 3) You thoroughly understand contract 4) Issuing elevator/co-op is solid/reputable

16 Purchase of put option Conditions 1) Good substitute for offensive hedge if unsure of topping action or you re not prepared to meet unlimited margin calls. 2) Good substitute for defensive hedge if unsure of topping action and willing to salvage premium if sell signal is negated.

17 Tools to use with poor basis and a BULLISH BIAS for futures

18 Deferred price contract Conditions: 1) Storage is either unavailable or too expensive relative to expected improvement in basis 2) Elevator or co-op is bonded and rock solid, since you are an unsecured creditor in the event of merchant bankruptcy

19 Do nothing at all Conditions: 1) You have decided to do nothing 2) You have reasonably priced storage available 3) Normal basis improvement will more than cover storage costs

20 TOOLS TO USE WITH GOOD BASIS Cash sales into spot market Cash forward contract Basis contract Sell cash and buy futures Sell cash and buy call option Minimum price contract

21 Tools to use with good basis and a BEARISH BIAS for futures

22 Cash sale into spot market Conditions: 1) Sale is offensive in nature (excellent price or objective hit) 2) You have known quantity and can move now 3) Normal basis gain is not likely to pay for continued storage 4) You are willing to re-own in futures or options if conditions change dramatically

23 Conditions: Cash forward contract 1) Sale is offensive (excellent price or objective has been hit) 2) You are not yet prepared to deliver OR forward delivery months offer reasonable return to storage 3) You are willing to re-own in futures or options if conditions change dramatically

24 Minimum price contract Conditions: 1) Sale is defensive in nature (blah price, but bleak outlook, too) 2) You still see chance for turnaround later, but buying back in futures or options is not an alternative 3) Premium being charged is not much more than the cost of selling cash and buying a call option instead.

25 TOOLS TO USE WITH GOOD BASIS and a BULLISH BIAS for futures

26 Minimum price contract Conditions: 1) Additional basis gain unlikely to cover further storage charges 2) Sale is offensive (locks in reasonable price) and reduces risk of bullish bias being wrong! 3) Premium being charged isn t much more than the cost of selling and buying a call

27 Basis contract Conditions: 1) Additional basis gain unlikely to cover further storage costs 2) Contract basis very close to spot basis 3) Opportunity to roll into later delivery month by paying any carrying charge at the time of the roll

28 Conditions: Sell cash and buy futures 1) Additional basis gains unlikely to cover further storage costs 2) Offers more attractive basis than basis contract 3) You will limit losses in futures to savings in storage costs 4) You are confident of both direction and timing of price gains

29 Sell cash and buy call option Conditions: 1) Additional basis gain unlikely to cover further storage costs. 2) Offers better basis than basis contract 3) You are not prepared for open-ended margin call risk 4) You are not confident in timing of price gains

30 TOOLS TO USE IRRESPECTIVE OF BASIS

31 Conditions: The courage call 1) Additional upside potential beyond highest reasonable price under current conditions can be covered with a cheap call 2) The call gives you the courage to price aggressively as prices approach your highest reasonable price 3) You will utilize your normal basis and futures decision making process to determine how you sell against the call

32 Writing covered call options Conditions: 1) You are willing to bear the risk of being short at an out-of-the-money strike price in exchange for premium offered 2) In the event the calls are exercised by the buyer, you are prepared to treat the resulting short position as a hedge and decide on the spot if you will stick with it. 3) You realize that writing covered calls does not substitute for price risk management in any way. It s only a price enhancement strategy.

33 Examples

34 Hedge with short futures position: The math: A hedge in December 2013 corn futures at $6.00 Basis at time hedge was established is -$0.30 Cash Equivalent price at time of hedge is futures price plus basis ($5.70) If futures rally to $7.00 and basis is steady at -$0.30 at time of cash sale: You owe $1.00 per bu. to settle hedge account. Your cash sale is at current futures price plus basis. ($ $0.30 = $6.70) The $1.00 hedge loss is 100% offset by gains in cash market. Net selling price: $5.70 is the same as the cash equivalent price at the time the hedge was established.

35 Hedge with short futures position: The math: A hedge in December 2013 corn futures at $6.00 Basis at time hedge was established is -$0.30 Cash Equivalent price at time of hedge is futures price plus basis ($5.70) If futures rally to $7.00 and basis narrows to -$0.20 at time of cash sale: You owe $1.00 per bu. to settle hedge account. Your cash sale is at current futures price plus basis. ($ $0.20 = $6.80) The hedge loss is 100% offset by gains in cash market. Net selling price: $5.80 the hedge allowed you to monetize (or capture) the basis improvement.

36 Hedge with short futures position: The math: A hedge in December 2013 corn futures at $6.00 Basis at time hedge was established is -$0.30 Cash Equivalent price at time of hedge is futures price plus basis ($5.70) If futures fall to $5.00 and basis is steady at -$0.30 at time of cash sale: You are paid $1.00 per bu. to settle hedge account. Your cash sale is at current futures price plus basis. ($ $0.30 = $4.70) The cash market loss is 100% offset by hedge gains. Net selling price: $5.70 the same as the cash equivalent price at the time the hedge was established.

37 Hedge with short futures position: The math: A hedge in December 2013 corn futures at $6.00 Basis at time hedge was established is -$0.30 Cash Equivalent price at time of hedge is futures price plus basis ($5.70) If futures fall to $5.00 and basis narrows to -$0.20 at time of cash sale: You are paid $1.00 per bu. to settle hedge account. Your cash sale is at current futures price plus basis. ($ $0.20 = $4.80) The cash market loss is 100% offset by hedge gains. Net selling price: $5.80 the hedge allowed you to monetize (or capture) the basis improvement.

38 Hedge with short futures position: The math: A hedge in December 2013 corn futures at $6.00 Basis at time hedge was established is -$0.30 Cash Equivalent price at time of hedge is futures price plus basis ($5.70) If futures fall to $5.00 and basis widens to -$0.50 at time of cash sale: You are paid $1.00 per bu. to settle hedge account. Your cash sale is at current futures price plus basis. ($ $0.50 = $4.50) Hedge gains partially offset cash market loss. Net selling price: $5.50. Widening basis is the risk in hedging.

39 Using a Put Option for a hedge: The math: With December futures at $6.00 and a -$0.30 basis; $5.50 put option premium at $0.50. Cash equivalent at time of transaction: Futures price ($6.00) minus put premium paid ($0.50) plus basis (-$0.30) = $5.20 cash equivalent.

40 Using a Put Option for a hedge: The math: With December futures at $6.00 and a -$0.30 basis; $5.50 put option premium at $0.50. Cash equivalent at time of transaction: Futures price ($6.00) minus put premium paid ($0.50) plus basis (- $0.30) = $5.20 cash equivalent. If futures rally to $7.00, basis holds steady, you hold put The $5.50 put would be worthless you ve given up the 50 cents. Cash price: Futures price ($7.00) plus basis (-$0.30) = $6.70 Net price is cash price minus put premium ($0.50) = $6.20 cash price. Because you can t lose more than the premium paid for the put option, you capture $1.00 of the $1.00 rally.

41 Using a Put Option for a hedge: The math: With December futures at $6.00 and a -$0.30 basis; $5.50 put option premium at $0.50. Cash equivalent at time of transaction: Futures price ($6.00) minus put premium paid ($0.50) plus basis (- $0.30) = $5.20 cash equivalent. If futures rally to $6.50, basis holds steady, you hold put The $5.50 put would be worthless you ve given up the 50 cents. Cash price: Futures price ($6.50) plus basis (-$0.30) = $6.20 Net price is cash price minus put premium ($0.50) = $5.70 cash price. Because you can t lose more than the premium paid for the put option, you capture $0.50 of the $0.50 rally.

42 Using a Put Option for a hedge: The math: With December futures at $6.00 and a -$0.30 basis; $5.50 put option premium at $0.50. Cash equivalent at time of transaction: Futures price ($6.00) minus put premium paid ($0.50) plus basis (-$0.30) = $5.20 cash equivalent. If futures fall to $5.00, basis holds steady, you take profits on put option at $1.00 ($0.50 profit). Cash price: Futures price ($5.00) plus basis (-$0.30) = $4.70 Net price is cash price plus profit on put option ($0.50) = $5.20 Plus, you gain back initial investment ($0.50) = $5.70.

43 Using a Put Option for a hedge: Sometimes, a put option doesn t cover 100% of downside price risk, so why use them? Because they allow you to protect downside risk yet still participate in a rally with a known risk. No matter how much you pay for the option, that s the most you can lose. If futures rally more than the premium paid, you are participating in the rally penny-for-penny. If you deduct the premium from the cash-price equivalent at the time of purchase (as I did in the examples), your only risk is basis. Therefore, use put options for downside price protection when basis is abnormally wide.

44 Using a Call Option to reown a cash sale: The math: With December futures at $6.00 and a -$0.30 basis; $6.50 call option premium at $0.50. Cash price at time of sale: $5.70. (Futures plus basis) Cash equivalent at time of transaction: Cash price minus call premium paid ($0.50) = $5.20 cash equivalent.

45 Using a Call Option to reown a cash sale: The math: With December futures at $6.00 and a -$0.30 basis; $6.50 call option premium at $0.50. Cash price at time of sale: $5.70. (Futures plus basis) Cash equivalent at time of transaction: Cash price minus call premium paid ($0.50) = $5.20 cash equivalent. If futures rally to $7.00, basis holds steady, you take profits on call option The $6.50 call option would be worth $0.80 ($0.30 profit) Cash price equivalent: $5.20 You gain back initial investment ($0.50) = $5.70 Also add in profit on call option ($0.30) = $6.00 You add (and regain) $0.80 of $1.00 rally.

46 Using a Call Option to reown a cash sale: The math: With December futures at $6.00 and a -$0.30 basis; $6.50 call option premium at $0.50. Cash price at time of sale: $5.70. (Futures plus basis) Cash equivalent at time of transaction: Cash price minus call premium paid ($0.50) = $5.20 cash equivalent. If futures drop to $5.00, basis holds steady, you hold call The $6.50 call would be worthless you give up $0.50 premium. Cash price: $5.70 Net price is cash price minus loss on call option = $5.20. Because you can t lose more than you pay for the call option, your net selling price is the same as the cash equivalent price at the time of the transaction despite a $1.00 drop in price.

chapter includes a workbook & full-length

47 Chapter 1: Assessing And Managing Risk Chapter 2: Become A Better Cash Marketer Chapter 3: Fundamentals of Hedging Chapter 4: Advanced Marketing Strategies Each chapter includes a workbook & full-length DVD. To Order: Call: or

48 Thank You Brian Grete Sr. Market Analyst, Pro Farmer

MARKETING ALTERNATIVES

2018 CONTRACT GUIDE MARKETING ALTERNATIVES We, at Crossroads Cooperative Association, would like to offer various marketing alternatives to our producer customers. Each alternative has its place and value