There’s a lot of mis-information about derivatives, options, collateralized debt obligations, etc. As usual, the media tends to portray them as reckless gambling, with no purpose other than to enrich bankers. That’s not the case.

I’ll begin by saying that both the government and the various financial institutions are not blameless in all this. But before we begin blaming, let’s understand what all these fancy things are.

And the answer to that question is: they are insurance.

Yup. They are a way to transfer risk from one person to another. Just like when you buy life insurance, or car insurance, etc. Let’s take simple term life insurance as an example. You might purchase a twenty-year, $100,000 policy for a premium of $400 per year. You will spend $8000. In financial terms, you have a guaranteed loss of $8000. However, you have avoided a possible loss of $100,000, the value of your life. If you die, your survivors will miss you, but they won’t miss your income, because they have the $100K.

Look at it from the insurance company’s point of view. They lock in a profit of $8000. But they have a potential loss of $100,000. If they sell lots of policies, and they’ve done their math correctly, the law of averages means they will come out ahead. The government further assures this by requiring them to keep fairly substantial cash reserves.

This is a simplistic example, of course, but it shows the basic concept. Now, let’s look at one that’s a bit more complex. Let’s assume you have a hundred-acre farm where you raise wheat. There are two bad outcomes: 1, a low price; and 2, a crop failure. More specifically, I’m going to say that any price below $5/bu is too low, and any yield less than 50bu/acre is a failure.

To protect against a low price, I want to BUY an option to SELL wheat at $5. This is a PUT option. According to the  Kansas City Grain Exchange options market, I can buy this for 33 cents per bushel, for September wheat. I’ll buy this insurance for 5000 bushels, so I am spending ~$1667. This is my maximum loss; this money is gone, just like an insurance payment.

When September rolls around, if the spot price of wheat is below $5, I can exercise my option and sell 5000 bushels at $5. Thus I have covered myself. I sell the rest of my wheat (if any) at the market price.

If the spot price of wheat is above $5, I let my option lapse. I sell all my grain at the current market price.

Here’s an example: Let’s say the spot price is $3, but I have a good harvest – 100 bu/ac.  I exercise my option to sell 5000 bushels at $5/bu. I sell the other 5000 bushels at $3 (market). I gross $25,000 (5000 *$5) plus $15,000 (5000 * $3), which is $40,000. But, I must subtract the $1667 “premium” I paid when I bought the option. I have ~$38,333 for my wheat.

To protect against crop failure, I buy an option to BUY  5000 bushels of wheat at $5/bu. This is a CALL option. These are trading at 32 cents/bushel. It costs me about $1600 for this.

At harvest, if wheat is above $5, I exercise my option (that is, I buy someone else’s wheat) and resell at market). If wheat is at, for example, $6, I make $1 per bushel profit, or $5000. This is independent of whether my crop was good or not.

Let’s say I get only 20bu/ac, and the price of wheat is $6. I sell my 2000 bushels at $6, or $12,000 total. I also exercise my option on the 5000 bushels, and I make $1/bu profit on those 5000 bushels, for an extra $5000. Total cash is $17,000. My option cost me $1600, so I net 15,900. Not a lot, but something.

Is there a drawback? Well, there can be. The person who SELLS me an option has almost unlimited risk. For example, the person who sold me the PUT option to sell wheat at $5/bu is in a world of hurt if wheat goes to, say $13, which it did not too long ago. He’s out $8* 5000 bushels, or $40,000.

This is why trading in options is not recommended for folks who don’t have deep pockets. The people who do have deep pockets, and are good at this, can make a lot of money. We call them speculators and we think they are evil people, but in point of fact they are simply providing a service to the farmers, just like insurance companies.

In the next post, I’ll talk a little more about what does and doesn’t work when dealing with complex financial instruments.