There are many risk management strategies that offer price protection for long hedgers involved in buying grain and oilseed products.
Grain processors, feed manufacturers, food companies and importers understand the impact that a price increase could have on their business. It is important that they familiarize themselves with various alternatives for mitigating this risk and protecting their bottom line.
Buying futures contracts allows long hedgers to lock in a purchase price for grain because a loss in the cash market is made by a gain in the futures market, and vice versa.
This strategy will satisfy the needs of many long hedgers, who have calculated the purchase price that allows their business to be profitable.
However, some hedgers would like the ability to establish a maximum purchase price for grain, while still being able to take advantage of a potential decline in grain prices. That is where options come in, offering price protection plus flexibility.
This module will describe how grain buyers can purchase call options to establish a maximum, or ceiling, purchase price for grain while still maintaining the opportunity to buy grain at a lower price.
Assume that it is August and a grain processor is looking to purchase wheat in November.
The normal basis for his area in November is 10 cents under the December Wheat futures price, which is currently $4.50 a bushel. This would give him an expected purchase price of $4.40, which is the December futures price minus the expected basis. The processor has determined that a purchase price of $4.40 will allow his operations to be profitable.
One alternative is to lock in the purchase price of $4.40 with a long futures hedge, by buying December futures at $4.50. However, the processor decides to buy call options to establish a ceiling purchase price, and retain the opportunity to potentially purchase wheat at a lower price.
By purchasing the call option, he has the right—but not the obligation—to buy futures at the strike price of the option.
In August, a December at-the-money call option with a strike price of $4.50 costs 15 cents.
With this call option, he will establish a ceiling price of $4.55, which equals the call option strike price of $4.50, plus the 15-cent premium he paid, minus the 10 under basis. If wheat prices increase, this is the maximum price he will pay.
Suppose the December Wheat futures price rises to $5.00, which would mean a cash price of $4.90, the futures price minus the expected 10 under basis.
Since the call option gives the processor the right to buy at 4.50, even though Wheat futures are at $5.00, the call option has a value of at least 50 cents, the futures price minus the $4.50 strike price.
Deducting the 15-cent premium gives the processor a net gain of 35 cents on his call option hedge.
The cash price of $4.90, minus the 35-cent gain provides the processor with an expected purchase price of $4.55 per bushel.
No matter how high wheat prices rise by the time he makes his purchase in November, assuming the basis is stable, the most he will have to pay for wheat is $4.55.
But suppose the December Wheat futures price declines below the $4.50 strike price. In this situation, the grain processor will still be able to take advantage of the lower price.
Say December futures decrease to $4.20 a bushel. Taking into account the 10 under expected basis, the cash price in the processor’s area would be $4.10.
Since the $4.20 futures price is less than the $4.50 strike price of the call option, the processor allows the option to expire and buys his wheat at a lower price in the cash market.
The most he will lose is the 15-cent premium he paid upfront. His net purchase price will be $4.25, which is the futures price of $4.20 minus the 10 under basis, plus the 15-cent premium.
With wheat prices rising, the net purchase price of $4.55 was higher compared to the $4.40 he would have locked in with the long futures hedge, the difference, essentially, being the option premium.
The processor was quite willing to pay the premium because it allowed him to secure protection from rising prices and, unlike the long futures hedge, still have the opportunity to pay a lower price for wheat in a falling market: $4.25 versus $4.40 with a futures hedge.
He will pay more in this scenario than the $4.10 had he not hedged at all, the difference, again, being the option premium. But, knowing that the price could just have easily have risen, he was willing to pay this cost to ensure a maximum purchase price for his wheat.
Keep in mind that the processor also has the possibility of selling his call option for any time value that it may still hold. Whatever he receives from selling the option would reduce his net purchase price even more.
The benefits of buying call options for the long hedger:
- He knows the cost of the option and the maximum loss up front, the option premium
- He is able to establish a ceiling price for his purchases
- He still has the ability to take advantage of lower prices
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 rising prices to have peace of mind of knowing that they have taken steps to manage the risk involved in purchasing these commodities for their business.
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