At this writing, the Kansas City Board of Trade (KCBT) July wheat contract price is up 11 cents and has increased 33 cents in the last six trading days. During the same six days, the Chicago Board of Trade July corn contract price increased from $4.29 to $4.57 or 28 cents. July corn prices continue to push wheat harvest prices higher.
The KCBT July wheat contract price had been trading in a sideways pattern between $4.90 and $5.10. The contract price broke out of the sideways pattern and has established an uptrend. The next target price for the July wheat contract may be $5.50.
If the KCBT July wheat contract price is below $5.20, the target price maybe $5.
Most elevators in Oklahoma and Texas Panhandle elevators are offering a harvest forward contract price about 40 cents less than the KCBT July wheat contract price. At this writing, the KCBT July wheat contract price closed at $5.23. Using a minus 40 cent basis implies a forward contract price of $4.83.
Producers that lock in a price by forward contracting at $4.83 may protect against higher prices by buying a KCBT July wheat call option contract for each 5,000 bushels forward contracted. At this writing, a KCBT July “at the money” $5.20 call option contract cost 32 cents per bushel or $1,600 per contract.
Forward contracting at $4.83 and buying a $5.20 call option contract for 32 cents produces a minimum price of $4.51 ($4.83 - $0.32 premium). If the KCBT July wheat contract continues to increase, the value of the call will increase proportionally and the net price will increase from the $4.51 guaranteed minimum price.
Another way to set a price floor is to buy a KCBT July put option contract. A KCBT $5.20 July wheat put option cost 27 cents per bushel or $1,350 for each 5,000 bushel contract. The expected minimum price is dependent on the estimated basis.
The market is offering about a minus 40 cent basis KCBT July for harvest delivery. If a minus 40 cent basis is used, the expected minimum price is $4.53 ($5.20 — $0.40 basis — $0.27 premium).
For June 2006, the central Oklahoma and Texas Panhandle harvest basis averaged about a minus 28 cents. The five year average basis is about a minus 27 cents. Using the five year average basis of minus 27 cents produces an expected minimum price of $4.66 ($5.20 -$0.27 basis - $0.27 premium).
The question is, “If you are using option contracts to set a minimum price, should you use put option or a call option contracts?” The answer normally depends on the forward contract basis.
If the forward contract basis is below average (-40 cents forward contract basis compared to -27 cents average basis), then the put option contract has the highest odds of producing the highest price. If the forward contract basis is above average (-20 cent forward contract basis versus a -27 cent average basis), then the combination of forward contracting and buying call options has the highest odds of producing the highest price.
This year's situation favors using put option contracts. An advantage for using the forward contract and the call option is that the minimum price is fixed. Using put options establishes a minimum price range because the actual minimum price depends on the basis the day the wheat is sold.
Another thing to consider when estimating the June 2007 wheat basis is that, at harvest, feed mills and feed lots will be biding for farmer wheat. The mills and lots may save the 20 plus cent elevator handling charge and profit margin by buying wheat at harvest. At least in the feed lot areas, this competition should result in a higher basis.
A question producers should be asking is, “Can I afford less than $4.83 for my wheat?” If not, forward contract some.
If producers can afford less that $4.83 but not less than $4.50, consider forward contracting and buying “at the money” KCBT July call option contracts or buying “at the money” KCBT put option contracts to set minimum prices.