There are many risk management strategies for price protection during uncertain markets. These strategies are helpful for grain and oilseed buyers like processors, feed manufacturers and food companies.
At times, long hedgers are interested in a strategy that provides up-side protection and the ability to take advantage of lower prices, at a lower cost than simply buying a call option. One alternative is to buy a call option and simultaneously sell a put option.
This module will describe how grain buyers can simultaneously buy calls and sell puts to establish a buying price range and to finance or reduce the cost of buying the call.
In an option strategy that creates a buying price range, purchasing a call option will set a ceiling price and selling a put option will set a floor price.
The floor and ceiling prices are determined by the strike prices of the options: the hedger would choose a higher strike price for the call option he is buying, and a lower strike price for the put option he is selling.
Assume that in August a food manufacturer is planning to buy wheat for his company in November. The normal basis for his area in November is 10 cents under the December wheat futures contract price, which is currently $4.50 a bushel.
The food manufacturer is comfortable with buying wheat at the expected price of $4.40, which will allow his company to be profitable.
However, he decides to incorporate options into his hedging strategy to take advantage of any downward price movement and ensure that the price he pays for wheat will not rise above a specific level.
The food manufacturer has many different strike prices to choose from to establish his buying range.
After considering the various strike prices, and taking into account his company’s objectives and risk exposure, he decides to buy an out of-the-money call option with a strike price of $4.60 for a premium of 15 cents premium, and simultaneously sell an out-of-the-money put option with a strike price of $4.30 for a premium of 8 cents.
This means that he will implement the strategy at a net premium cost of 7 cents, the difference between the 15-cent premium he paid, and the 8-cent premium he received.
With this strategy, he is able to establish a ceiling price of $4.57, which equals the call strike price of $4.60 minus the expected 10-cent basis plus the 7-cent net premium he paid.
He also establishes a floor price of $4.27, which equals the put strike price of $4.30 minus the expected 10-cent basis plus the 7-cent net premium he paid.
The food manufacturer now has a buying price range for his wheat of $4.27 to $4.57. This means that no matter what happens in the futures market during the life of the option, his net buying price will be no higher than $4.57, and no lower than $4.27, subject to any change in the basis.
If the futures price goes up to $5, his net purchase price will be $4.57, which is the futures price of $5.00 minus the 10-cent basis minus 40 cents, which is the difference between the futures price and the $4.60 call strike price plus the 7-cent net premium he paid.
If the futures price drops to $4, his net buying price will be $4.27, which is the futures price of $4.00 minus the 10-cent basis plus 30-cents, which is the difference between the $4.30 put strike price and the futures price plus the 7-cent net premium he paid.
The buying price range is 30 cents. The manufacturer can set his price range based on the associated strike prices.
Now that the food manufacturer knows the minimum and maximum prices he will pay for wheat, his company can plan and make decisions for their 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 higher prices to have peace of mind knowing that they have taken steps to manage the risk involved in buying these commodities.