In the last article, the strategy of buying call options was discussed. As a commodities buyer, there are several option strategies that you would typically deploy:
The second strategy of selling puts is usually not advised unless the environment is stable, and the risk involved is fully understood. We consider the third strategy in this article that establishes a price range with little option premium spent.
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.
|Date: March 1, 2018||Jul-18 Futures price = $3.93|
Bought Jul-18 Calls at $4.10 strike (priced at $0.10)
|Date: June 14, 2018||Scenario 1
Corn cash prices fell to $3.63
Corn cash prices rose to $4.20
|Physical position||Took shipment at $3.63
Made $0.30 gain in cash market
|Took shipment at $4.20
Made $0.17 loss in cash market
|Options position||Call expired at $0 value
Put exercised at $0.17 loss
|Put expired at $0 value
Call exercised with $0.10 gain
|Net result of whole transaction||Effectively paid $3.81 for the corn
Physical transaction - 3.63
Net option premium - 0.01
Loss from put exercise - 0.17
|Effectively paid $4.11 for the corn
Physical transaction - 4.20
Net option premium - 0.01
Gain from call exercise + 0.10
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.