A Put Floor, a Lender's Objections, and a Hailstorm
In August a producer expects to harvest and sell 25,000 bu of corn in late October. December futures are $4.40 and the expected harvest basis is 20 cents under. Rather than sell futures, she buys five December $4.30 put options at 12 cents per bushel ($600 per contract, $3,000 total, commissions ignored). Her lender objects: 'You paid $3,000 for something that expires worthless if prices rally, and you will still have to meet margin calls on it.' A neighbor instead sold 25,000 bu of December futures at $4.40. At harvest, December futures are either $3.95 or $4.60.
1. Compute her net price per bushel in both price scenarios and state her floor. Then compute the neighbor's outcomes and explain what the difference between the two strategies represents.
Read the worked answer
Assume the harvest basis comes in at 20c under in both cases.
Floor formula: net price = strike - premium + basis = $4.30 - $0.12 - $0.20 = $3.98.
| Futures $3.95 (cash $3.75) | Futures $4.60 (cash $4.40) | |
|---|---|---|
| Cash sale (25,000 bu) | $93,750 | $110,000 |
| Put result | 35c intrinsic = $1,750/contract x 5 = $8,750, less $3,000 premium = +$5,750 | expires worthless = -$3,000 |
| Net | $99,500 = $3.98/bu | $107,000 = $4.28/bu |
Neighbor (short futures at $4.40):
- Futures $3.95: cash $3.75 + futures gain 45c = $4.20
- Futures $4.60: cash $4.40 - futures loss 20c = $4.20
Flat $4.20 in both states.
The difference. Her floor is 22c below his: 10c because she chose a $4.30 strike that is 10c out of the money, plus the 12c premium. That 22c is the price of keeping everything above $4.40 - her upside is $4.28 versus his $4.20 at $4.60, and her advantage grows dollar for dollar above the strike + premium. Framing the premium as a cost is correct; framing it as a waste is not, because it buys the right to walk away.
2. Address the lender's two objections directly, and explain what happens to the $3,000 if the put expires worthless.
Read the worked answer
Objection 1 - margin. Wrong. A long option is paid for in full at purchase; the premium is the entire capital at risk, and there is no initial or maintenance margin and no daily variation call. The lender may be thinking of a short option, which is margined (and has far larger risk). Her cash commitment is limited to the $3,000 already paid.
Objection 2 - expiring worthless. That is the intended outcome in a rally, not a failure: it means the cash grain sold for more than the floor. Expiring worthless caps the loss at the premium - 12c per bushel, or $3,000 on 25,000 bu - and no more. The put never obligates her to deliver or to buy anything; if she does not exercise, the contract simply ceases to exist.
Two refinements worth telling the lender:
- She does not have to hold to expiration. If the market rallies she can sell the puts back and recover residual time value, reducing the effective cost below 12c.
- The premium is a marketing expense that should be compared with the 22c of downside protection it retains, not with zero.
Her options position also should not be ignored in the cash-flow plan: if she intends to exercise, she needs the deliverable position or to offset the put and sell cash grain, depending on her account documentation and the firm's exercise procedures.
3. Hail cuts the harvest to 10,000 bu. Compare her position with the neighbor's, and state what should be done with the excess option contracts.
Read the worked answer
Neighbor (short 25,000 bu futures, owns 10,000 bu). He has 15,000 bu of naked short exposure.
- If December is $3.95, he profits on the extra 15,000 bu: 45c x 15,000 = $6,750 - a windfall from a crop failure.
- If December is $4.60, he loses 20c x 15,000 = $3,000 with no grain to sell against it, and the loss grows without limit as prices rise. He must buy back the excess 15,000 bu at market.
A production shortfall converts his hedge into an open-ended speculative short - the classic over-hedge problem.
Her position (5 puts, 25,000 bu of coverage). Three puts (15,000 bu) cover nothing. But a put is a right, not an obligation:
- Worst case she lets the three extra puts expire and forfeits their premium: $600 x 3 = $1,800 - a known, bounded number.
- Better, she sells them back before expiration and recovers residual time value, possibly most of the premium if volatility has risen.
No margin call, no delivery obligation, no forced purchase of grain to cover. On 10,000 bu she still has the floor of $3.98 on what she actually harvested. This asymmetry - bounded loss on a production shortfall - is the main argument for options over futures for crops that are not yet in the bin.