There are many risk management strategies for price protection during uncertain markets. These strategies are necessary for grain and oilseed sellers like farmers, merchandisers, grain elevators and exporters.
At times, short hedgers are interested in a strategy that provides down-side protection and the ability to take advantage of higher prices at a lower cost than simply buying a put option. One alternative is to buy a put option and simultaneously sell a call option.
This module will describe how grain sellers can simultaneously buy puts and sell calls to establish a selling price range and to finance or reduce the cost of buying the put with the premium received from selling the call.
In an option strategy that establishes a selling price range, buying a put option will set the floor price and selling a call option will set the ceiling price. The ceiling and floor prices are determined by the strike prices of the option, so a hedger would choose a lower strike price for the put option he is buying, and a higher strike price for the call option that he is selling.
Assume that a farmer has just planted his soybean crop and is planning to harvest and sell his soybeans in October.
The normal basis for his area in October is 10 cents under the November Soybeans futures price, which is currently $9.50 a bushel.
The farmer is comfortable with selling his soybeans at the expected price of $9.40, which will allow his operations to be profitable.
However, he decides to incorporate options into his hedging strategy to be able to take advantage of any upward price movement and, at the same time, ensure that the price he gets for his soybeans will not drop beyond a specific level.
The farmer has many different strike prices to choose from to establish his selling range.
After considering the various strike prices, and taking into account his objectives and risk exposure, he decides to buy an out-of -the-money put option with a strike price of $9.30 and a premium of 20 cents. He simultaneously sells an out-of-the-money call option with a strike price of $9.80 for a premium of 12 cents.
This means that he will implement the strategy at a net premium cost of 8 cents: the difference between the 20-cent premium he paid and the 12-cent premium he received.
With this strategy he is able to establish a floor price of $9.12, which equals: the put strike price of $9.30 minus the expected 10 cent basis minus the 8-cent net premium he paid.
And he establishes a ceiling price of $9.62, which equals the call strike price of $9.80 minus the expected 10 cent basis minus the 8-cent net premium he paid.
The farmer now has a selling price range for his soybeans of $9.12 to $9.62.
If the Soybeans futures price drops to $9.00, his net selling price will be $9.12, which is the futures price of $9.00 minus the 10-cent basis plus 30 cents, which is the difference between the $9.30 put strike price and the futures price minus the 8-cent net premium he paid.
On the other hand, if the Soybeans futures price goes up to $10.00, his net selling price will be $9.62, which is the futures price of $10 minus the 10-cent basis minus 20 cents, which is the difference between the futures price and the $9.80 call strike price minus the 8-cent net premium he paid.
The selling price range, 50 cents, is the difference between the two strike prices. The farmer can set his price range based on the associated strike prices.
Also, it is important to keep in mind that, as the seller of the call option side of the strategy, he will be required to post a performance bond upfront at the time that he sells them.
Now that the farmer knows the minimum and maximum prices he will receive for his soybeans, he can plan and make decisions for his operations with a higher level of confidence.
No one can predict the future, but hedgers can take steps to manage it. Using grain futures and options allows those who need protection against falling prices to have peace of mind knowing that they have taken steps to manage the risk involved in buying these commodities.