For a commercial importer, the purpose of buying futures contracts is to protect himself against potential price increases in his physical imports, between the time they enter into a purchase agreement and the time the physical shipment takes place. When using futures to hedge, you are locked in to the price you contracted to buy at. You are protected against rising prices, but you are not able to benefit if prices fall.
By buying a Call Option instead, you establish a ceiling price for your purchase. The additional benefit is that, should prices fall , you have the potential ability to take delivery of the physical commodity at a lower price.
The better you understand options, the more versatile they become as a hedging tool. The key to using options successfully is to match an appropriate strategy to your particular objective. While options can be used aggressively for speculation, their conservative use to protect pre-established profit margins would be more relevant to a commodities importer.
With that in mind, we consider the basic hedging strategy deployed by a physical commodities importer – buying a call option.
As a practical illustration, assume that it is now March 1. You have purchased 500 metric tons (equivalent to about 20,000 bushels) for shipment in June. The July corn futures contract (code: ZCN8) is currently trading at $3.93 per bushel, which should reflect the fair value of corn for June/July shipments. You would be delighted if the price of corn falls below $3.93 by the time you pay for the purchase in June, but you want to protect yourself in case corn prices rise significantly above $3.93 by then.
The size of a CBOT corn option is 5,000 bushels, so you would buy four CBOT corn call options to fully hedge against your physical exposure of 20,000 bushels. The two key parameters you would need to select are the contract month and the strike price of the call option to buy.
Let us say that it is now June 14, and the cash price of corn has fallen to $3.63 per bushel. You paid for your shipment of corn at $3.63 per bushel, and allowed your call options to expire. The profit margin you have now achieved is originally planned margin (when the projected price was $3.93), plus the additional $0.30 ($3.93 – $3.63) due to the fall in corn prices, minus the premium paid for the option. Your net transaction cost was $3.80 per bushel in this case.
Had corn prices increased instead, the corn option would have capped your net transaction cost to no more than $4.07 per bushel.
Had you taken a futures instead of a call options position, you would have been protected against the risk of a rise in corn prices, and as you would have locked into the $3.93 price. However, you would not have been able to benefit had prices of corn fallen. With a corn option, you have the added advantage of being able to earn additional profits if corn prices fall further than the premium paid for the option, while being protected against the risk of a rise in corn prices.
|Date: Mar 1, 2018||Jul-18 Futures price = $3.93|
|Bought Jul-18 Call at $3.95 strike Paid $0.17 premium for each call|
|Date: June 14, 2018||Scenario 1 Corn cash prices fell to $3.63||Scenario 2 Corn cash prices rose to $4.10|
|Physical position||Took physical shipment at $3.63 Made $0.30 gain in cash market||Took physical shipment at $4.10. Made $0.17 loss in cash market|
|Options position||Call allowed to expire, so $0 gain||Exercised Call at $3.90, so $0.20 gain|
|Net result of whole transaction||Effectively paid $3.80 ($3.63 plus $0.17)||Effectively paid $4.07 ($4.10 minus $0.20 plus $0.17)|
Read more on how buyers and sellers of grains and oilseeds utilize options to hedge their position to manage price risk. The course will enhance the hedger’s understanding of the different strategies available as well as how the basis affects prices.