There are many risk management strategies available that offer price protection during uncertain markets for those involved in producing or selling grain and oilseed products, such as farmers, merchandisers, grain elevators and exporters.
There are times, when sellers expect the market to remain relatively stable.
In this type of scenario, rather than looking for protection against a possible decline in prices, sellers may instead seek ways to increase their selling price.
This module will describe how grain sellers can sell “call” options as a strategy for potentially receiving a higher net price for the grain they’re selling.
Let’s assume that it is April and a corn farmer has just completed his planting, and is looking ahead to harvesting his corn in November.
The December corn futures price is currently $4.25 a bushel. If prices remain stable as he expects they will, this would give him an expected selling price of $4.25.
The corn farmer is comfortable with this price, because he knows that his operation will be profitable if he receives $4.25 a bushel for his corn. But if possible, he would still like to find a way to increase his selling price.
One way to do this is by selling corn “call” options. As the option seller, he would collect a premium upfront from the option buyer. He could potentially increase the net sell price of his corn by the amount of the premium he receives.
The corn farmer decides to sell an out-of-the-money December corn call option with a strike price of $4.35 for which he receive a 12-cent premium.
By doing this, he establishes a maximum net selling price of $4.47 a bushel, which equals:
- the $4.35 option strike price
- plus the premium
Again, the goal of this strategy is for the corn farmer to be able to retain the premium he received from selling the call option, which he can then add to his net sell price.
In order for this to happen, the corn market must remain relatively stable.
The futures price should not decline lower than $4.13, which is the current futures price of $4.25 minus the 12 cent premium he received.
For example, suppose corn futures decline to $4.20 per bushel.
The corn farmer’s effective selling price would be $4.32, which is
- the futures price,
- plus the 12-cent premium he received
As long as the futures price stays below the call option strike price, the call option is not likely to be exercised—the holder of that call option will not want to exercise an option to buy corn at $4.35 a bushel if he can pay a lower price for it in the cash market.
However, keep in mind that the corn farmer’s goal is to sell corn at a higher price than the current market of $4.25.
If corn prices actually do decline, his protection against lower corn prices will be limited to the 12-cent premium he received for the call option.
For instance, what if December corn futures decline to $4.00 a bushel? The corn farmer will retain the 12 cents he received for the $4.35 call option since it will not be exercised, but he will receive a lower price for his corn than the $4.25 he was initially facing.
His effective selling price will actually be $4.12, which is
- the futures price,
- plus the 12-cent premium.
So selling the call option gave him some protection against lower prices, but only to the extent of the 12 cent premium he received.
Remember that the farmer essentially established a maximum or “ceiling” price for his corn by selling the call option, which he will reach if the futures price increases above $4.47—the $4.35 strike price plus the 12 cent premium
The call option obligates him to sell corn futures at $4.35 even when corn is priced higher in the market. If December corn futures were to increase to, say, $4.60 per bushel, the call option will be exercised, requiring the farmer to sell corn futures at the $4.35 strike price, even though they are priced at $4.60 in the market.
While this is higher than the $4.25 he expected to receive for his corn before he initiated the hedge, it did not allow him to take full advantage of higher prices in the corn market.
In summary, selling call options can be a way for a short hedger to increase their selling price, but it is not without its risks. Again, the effectiveness of this strategy is contingent upon prices remaining relatively stable.
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