Call Options For Commodities Buyers

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.

• Selecting contract month:  While CBOT corn futures are listed for five contract months for each calendar year – March, May, July, September and December, CBOT corn options are listed every month.  You may therefore choose an option which matures close to your transaction date, as the price of that option would best match the prevailing physical exposure.  In this example, the July 2018[1] corn call option would be selected.
• Selecting strike price:  CBOT corn option strike prices are listed in increments of $0.10 per bushel at the start, and in increments of $0.05 as the option gets closer to maturity date.  When you made your corn purchase in March, the price of $3.95 per bushel would enable you to achieve your planned profit margin, and the options are listed in $0.10 increments at that time. Looking at the premiums for a July 2018 call option, the premium was $0.14 for a strike price of $4.00, and $0.17 for a strike price of $3.90. As you would have priced in a good margin buffer for your corn purchase, you might have purchased the call with the higher strike price to save on the premium that you had to pay. In the illustration, we assumed the $3.90 strike was purchased.

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.

1. CBOT options expire on the last Friday of the month prior to the contract month. If your shipment is in June, the July options contract would expire on June 22, covering the bulk of your exposure. If the option is in-the-money, and is held beyond that date, it would have exercised into the underlying July futures contract, giving you until Friday July 13 to close your futures position.