Episode 8: Let's Talk Skew

Puts are one of Rodney’s favorite selling strategies – why? Because the farmer’s covered if the price goes up or if the price goes down. But there’s a reason most farmers the guys work with don’t like using puts, which has a lot to do with skew. Rodney and Gabe dig into the psychology behind selling with a cash contract rather than trading options, what bad originating looks like, and the benefits for using a floor product. 

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TRANSCRIPT.

Rodney: Hey, let's talk skew. It's one of my favorite things that I've learned about since I've been at Indigo. So your team at Indigo on the global markets group, like you said, you've been really intentional about kind of having a diverse group. I don't know if we said it on this before, you call me your worst hire because I'm the least diverse person that you've hired on.

Gabe: That's right.

Rodney: But I still, as we're interviewing for these newer roles, I'm quick to tell people that we have a good chunk of our group has a pretty broad understanding of agriculture in general. Right? And it's not all of it, but it's a lot of it has a pretty broad understanding. And then inside of that, each one of us has our own kind of really deep understanding of a different section, right? So mine happens to be around cash grain and maybe decision-making. We've got another guy that's more on the merchandising side. We've got some guys that are on options and all this stuff.

Rodney: So I've done a lot of options in the past. I have always loved puts. All right? Puts are my absolute favorite marketing strategy depending on what's happening. And what I love about puts is it's like a futures only contract because it doesn't make me pick where I'm going to deliver. It just allows me to set a price and if the price goes up, I benefit. If the price goes down, I'm covered. I know what I've got in it, I love it. Right? Farmers hate puts.

Gabe: I know it.

Rodney: Hate puts. And so they would rather sell cash or a futures only contract, right? So if they don't like the basis of that. This is what I normally run into. I'm going to do a future's lock, right? And then I'm going to buy a call, which is going to ... Exact same effect, right? So I have unlimited upside with a minimum price locked in. So if I do it with the put, as the price goes down, the put is going to appreciate in value to offset the futures going lower.

Gabe: I love that I'm listening to you explain to me how puts work.

Rodney: The options guy. By the way, anyway, listen, Gabe is the options guy. So I'm actually explaining it to the farmer. Maybe that's the listener. So the call option does the exact same thing because I've already sold the grain. I'm already short futures. And if the price goes lower, my call option actually loses value but I've already hedged my grain. If the price goes higher, I've locked in my price already with the futures lock, but my call option appreciates in value, giving me upside. Got it?

Rodney: Here's the problem and here's the reason I love puts. One, I just said they both do the same thing, but if I do a futures lock and attach a call option to it, one, I'm paying for a hedge derive fee. I just paid an extra nickel for literally no more protection. I just increased the cost of my strategy by a nickel for nothing. And then since then, I've talked to Nick specifically on our team that understands skew really, really well and talked to me about skew. And he shows me these skew charts because they just ... People love when their thoughts are confirmed. And it's confirmed for me that puts are better than calls because ... So talk to me about that skew on the call side.

Gabe: Well, so like we talked about in grain, panic generally happens ... Scenarios where the market panics, which creates more volatility, tend to be correlated to higher prices in corn. And when we think about overproduction, overproduction doesn't really in general lead to a ton of market volatility. It's calmer. And so if I think about if I buy a put or a call and I'm buying an out of the money call or I'm buying an out of the money put, however you want to look at it, if the market's at 350 and I'm looking at the 340 put and the 360 call, the put's going to be a little cheaper than the 360 call. Even though those – 

Rodney: You know, I never knew that. For all the years I've been doing options, in my head I had it if corn is 350 and I'm looking at a 340 put and a 360 call, they should be the exact same price.

Gabe: Exact same thing. Yeah.

Rodney: And that's not true.

Gabe: That's not true.

Rodney: Yeah.

Gabe: Yeah. Well, so that's the skew, right? So the market understands that if the price is heading lower, it's probably cause we're achieving more certainty, which creates less volatility. And that's what it comes down to. I've had the same experience you have in terms of talking to folks. Part of it is that, talking about them hating puts, it isn't as intuitive to think about using a put. The math, even though it's only one thing instead of two, it gets complicated when you think about buying a thing that goes up in value when the market goes down. That's a mouthful right there. And I think that's why people do what you're talking about in terms of setting the futures and then buying a call. Because it is. It's more intuitive and easier to understand.

Gabe: I stopped running my head against the wall to push that years ago because somebody would call up and wanted do that and you'd say, "Oh, you could just buy them in price put," and they're like, "Well, yeah, but I wanted it." Okay. At the end of the day, the most important pieces are you're taking an action, you're putting in place from risk management. I'm not going to talk you out of doing those things. But yeah, I think you're right. I think for a lot of folks, buying a put as opposed to setting futures and buying a call is a better way to go.

Rodney: So I actually feel bad about some of the decisions I've made around presenting these products to guys. Because one, you just said you're not going to fight that fight. So I fought that fight for a long time and I'm sure we'll go over some stories at some point about all those fights that I fought and lost. But I'm really passionate about the fact that a put is a better strategy in a lot of cases than a hedge derive and a call option. But you're fighting a few things. One, like you said, that counterintuitive thing, the farmers is generally more comfortable with the cash price. But more importantly I think than that is I'm constantly compared to, as an originator, did the farmer win on this transaction?

Gabe: Oh man. Man. Oh, man.

Rodney: Yeah. Let's hear it. Yeah.

Gabe: That's the whole, the call didn't work. Right? The option didn't work. That's probably, talk about having done this for awhile, one of the most important lessons that you can get people across the line on, especially when they're in the position of selling these things, is the value of those strategies isn't that it might pay out. It's that you did anything right now. Oh man, sorry. I used to teach options classes to farmers, right? Like just, "Hey, here's how you use options on the exchange and everywhere else." And they would say, "Well, I bought some options and they didn't work for me." "Well, what do you mean they didn't work?" "Well, I paid 20 cents for them and they didn't pay out." "So okay, let's talk more about that." Right?

Gabe: Because they're comparing against, what if I just sold cash. And I think the conversation you and I both go down when a farmer is having that discussion with us, if they say, "Well, I don't think that option is going to work because I could just sell cash here," then it's like, "Cool, please sell some cash. Don't pay for any of this stuff. Just sell some grain, man."

Rodney: Yeah. In general, I started this conversation by saying you should sell cash. Right? And yeah. We're at options because you think something else may happen or you're worried or it's like insurance. Yeah. And back to that winning, so let's be clear. I want to be crystal clear here. Let's do beans because I never do beans. You buy a $9 put or you do a head at $9 and buy a $9 call. Right? So let's ignore skew for a second and just pretend that those options are the same price.

Gabe: So if the market's at nine bucks and you're looking at the $9 put and call, they should have the same price.

Rodney: Yes. That's correct.

Gabe: It's a different …

Rodney: That is different. Yeah. I appreciate the clarification there. Okay. So one, I just got dinged for a hedge derive fee on the call option. Right?

Gabe: No, on the futures lock.

Rodney: I'm sorry, on the futures lock with the call option.

Gabe: Yep.

Rodney: Yep. I paid the same amount for the call or the put depending on what I did. So let's say my futures lock was a nickel. I'm a nickel behind using the hedge derive with a call option strategy. Same strategy. Same thing. So beans raise to $11. Two different farmers. Here's how it works every time, right? Farmer A that bought the put says, "That was a waste." Right?

Gabe: Yeah.

Rodney: "Beans went to $11 and you talked me into buying a put."

Gabe: That's because you're a horrible person, Rodney.

Rodney: Horrible originator, right? So in my mind, I'm saving them a nickel on that fee. He's still got his $11 beans or whatever it went to, but I'm the bad guy. The other guy, I hosed him for an extra nickel, right? Goes up two bucks and he says, "Oh yeah, I just cashed in two bucks." So it's one of those things. Actually the guy with the put ended up in a better position. And frankly, man, there are very few guys I worked with that I would actually go propose the put as the solution. And more because of outcomes than the risk management themselves.

Gabe: Well, I mean, the secret there is ultimately the framing, right? In this scenario you laid out, you could literally just say, "Do you want to lock in a floor with upside for 20 cents? Do you want to lock in a $9 floor with unlimited upside for 20 cents? Or do you want to lock in a $9 floor with unlimited upside for 25."

Rodney: Yeah, I suppose I could do that.

Gabe: Let's see. So as we're talking through this, it occurs to me something that we could do that's responsible is having a floor product that really looks at it that way and just does that so that we don't double hit somebody and remove kind of that framing. But the other piece of it is, the reason people do those minimum price transactions is it does give them more control over things. That they could exit the put when we rally 50 cents and probably still get something back and keep going or do some other strategies. But I mean, that's what it comes down to, right? And the challenge is because it's a function of how the instruments are represented, how the different pieces are, you can't just go, "Do you want a floor and pay unlimited side for 20 or 25" because they're going to see those different pieces and be like, "Oh, that put's worthless. Why did we bother doing that?"

Rodney: Yeah. That's great, man. I wish I would have tried that. Like an AB test back in the day.

Gabe: Yeah. I mean, I know it would have worked. But it goes back to if somebody is advanced enough that they're willing to kind of have those conversations, they want to see the pieces. They want some of that control, which is I think a super appropriate reason to look at it. It just takes a couple more hops to think about it. I'm sure I've told the very quick anecdote that there's a guy that I worked for for a long time who's probably the best portfolio manager I've worked for. When we'd have an options conversation, he'd shut everything down, get out his notebook. And that guy had been doing it, whatever I've been doing it, he'd been doing it 10 plus more years than me. But he'd always write all the pieces down because it does get complicated. It often is not an intuitive series of thoughts. But yeah.

Rodney: Yeah. Also from a consumer standpoint, it's reasonable to pay a premium to better understand the product you're using. Right? I'm trying to think of an example of that, but there's definitely things that you could pay more to fully understand the product. What's an example of that?

Gabe: I don't know.

Rodney: There's an example.

Gabe: People pay more to better understand the product? Is that you're going to come and read me the manual?

Rodney: Maybe not.

Gabe: I think maybe there's ... Is there a premium version of something that comes with extra support? I feel like maybe that's what you're talking.

Rodney: Yeah, so maybe this is a terrible example I think, but maybe like LinkedIn, right? So on LinkedIn I can see that somebody viewed my profile, but if I pay an extra, I don't know, I have no idea what people are trying to hit me up for. I don't care.

Gabe: 37 cents.

Rodney: Yeah, if I paid 37 cents, they'll show me the name and occupation of the person that looked at my profile. So I don't know, maybe people are willing, even your option of, "Hey, you can pay 20 cents per floor or 25 cents for a floor." But in the 25 cent one, you fully understand it because it's more intuitive. Right? I agree that call options are more intuitive. Maybe a guy still picks that, but not me. For the record, not me ever. Puts every time.

Gabe: I think if you frame it up as do you want to pay 20 or 25 cents for literally the same thing, some people will take it. I mean there's a name for it, right? So if you buy a put option, the way you can synthetically create a put is you buy a call and sell futures. We call that a synthetic put option because it is literally, they are the same. You just pay two transaction fees instead of one.

Rodney: Yeah. Right, right.

Thanks for listening to the GrainWaves podcast. If you'd like to learn more about how Indigo can help your farm be more profitable, you can find us here.

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