Put And Call Strategy For Commodities Buyers

Previously, we had treated the buying of a Call Option as taking up an insurance policy.  To recapitulate, in the long futures strategy, you had locked into the price of corn and your profit margin. In the long call options strategy, you were protected against the increase in corn prices, and profit from a significant fall in corn prices.  

In the long call-short put strategy, the objective of the strategy is to establish a price range for the price of corn with little premium spent.  To meet this objective, you purchase a call and sell a put to help off-set the money spent on the call.  This strategy limits the amount of profit that can be achieved if prices move down below the put strike but can be attractive with a low premium outlay and protection offered from the call.

We made use of the same data as before. In March, the price of the July corn futures contract was $3.93 per bushel.  By mid-June, both the cash price and the July futures price of corn fell to $3.63 per bushel. You entered a contract in March to purchase 500 metric tons (equivalent to 20,000 bushels) of corn, and took shipment at $3.63 in June.

In the long call-short put strategy, it is assumed that you had taken a perfect hedge against your 20,000 bushels of corn.  As such, you would have sold four¹ put options and bought four call options.  Let us assume that you are prepared to take some moderate risk, so long as the final net cost of your deals are kept within ±$0.20 of the target price of $3.93.  After reviewing the option premiums², you decided to sell your puts at a strike price of $3.80, and to buy your calls at a strike price of $4.10. The put option was priced at $0.09, and the call option was priced at $0.10. So you paid a net premium of $0.01 for each long call-short put options position.

For purposes of determining the net profit/loss of the strategy, the calculation was carried out on a per contract (5,000 bushels) basis. The net result of the strategy, summarized in the following table, showed the net price that you had to pay for your corn purchase, when the corn prices fell to $3.63 and when they rose to $4.20. You had taken a conscious and moderate risk, by keeping the net cost of your purchase within a price range of $3.81 to $4.11.  We would add that, had prices stayed flat, you would have only paid out $0.01 in net premium.  The long call-short put strategy is a very cost-effective way to structure a hedge.

1. Your physical purchase was 20,000 bushels. The size of the CBOT corn put contract is 5,000 bushels. To match your physical purchase, you would therefore enter into a contract for four put options.
2. Options players typically choose out-of-the-money options as their premiums are much smaller.