Session 1, Lesson 10 / BUYING CALL OPTIONS

When using call options for grains, it is important to look at them as being part of a total investment trading program. That’s where good planning and a clear explanation of your strategy becomes important. We need to remember that purchasing call options will allow you to benefit from a rising market. If a trader holds the cash product   and purchases a call option just to try to benefit from the rising market, he is speculating as much as anyone else. But now let’s look at the purchase of this call option in the context of hedging  and see how it fits in.

The most common use of call options in investments  is in the area of replacement or repurchase hedges. That term is used to describe a situation where cash product is sold and then a call option is purchased as an alternative to continued storage. This is also done very commonly with futures. Some people will argue that to do this is not really a hedge strategy. I would strongly disagree. doing that you have price exposure during the entire storage period. If prices happen to rise, you have a higher selling price, and if they fall you’re a loser twice. Not only do you receive a lower price for your crop but you also have the cost of storage. Some argue that their bins are paid for so they really don’t have any storage costs, but of course as good marketers you know that is not necessarily true.

One alternative is to sell the grain and repurchase it with a call option. What are the benefits of replacing it with a call option? First of all, you have eliminated the downside risk. As an example, lets say that when you put the corn in the bin, the price is $2.50. By purchasing a call option your risk is limited to the amount of premium that you pay – in this case say that the cost is $.10. If, during the time you would have stored that corn, prices drop 30 cents. Not only will you have lost the 30 cent decline in price, but you will also have lost your interest and other storage costs. In this case, the call option helps you better manage you money. You did not suffer the loss of price, and you had a cash flow advantage by getting the dollars today and commiting a much smaller amount of money in the call option.

In the case of a rising market, having the corn stored may have been a bit more advantageous but your call option may cost you no more than what you would have lost in interest. If that’s the case, the two become virtually equal. Let’s look at a comparison between storing corn and buying a call option in both rising and falling markets.

Assumptions: Harvest corn October 15. Interest cost at 12%.

PRICES GO DOWN

STORE UNTIL JUNE 15                     SELL CASH/BUY OPTION
Cash price Oct. 15         = 2.50       Sell cash Oct. 15       = 2.50
Sell cash June 15          = 2.20       Buy July 250 call       =  .20
Interest cost              =  .20       (premium & commission)
Net realized selling price = 2.00       Net realized selling price = 2.30

PRICES GO UP

STORE UNTIL JUNE 15                     SELL CASH/BUY OPTION
Cash price Oct. 15         = 2.50       Sell cash Oct. 15       = 2.50
Sell cash June 15          = 3.00       Buy July 250 call       = -.20
Interest cost              =  .20       (premium & commission)
Net realized selling price = 2.80       Sell July 250 call June 15 = +.50
Net realized selling price = 2.80

In our example that for simplicity, the call option and the cost of interest were the same. This will not always be true, but by pushing the pencil you should be able to quickly determine what difference, if any, exists. Where prices decline, buying the call option proved to be the better alternative. Not only did we realize a higher selling price by 30 cents, but we also had the use of our money the entire 8-months.

In the example where prices went up, both strategies yielded approximately the same net selling price. Again, the advantage goes to the option because we had use of the money during this time period plus there would have been additional storage costs which were not accounted for by interest alone. Thinking that selling your grain at harvest and buying call options is always the best alternative I’ll add that this is not always true. Many times you will find that making the sale and replacing it with a call option makes sense.

As you can see from the illustration, this is not a speculative move. In fact, it’s plain good management. You’re reducing your downside risk while still being able to benefit from a market rise. To say that converting the stored grain into an option is speculative is simply not accepting the tools that are available to you. Is using a tractor instead of a horse not real farming? At the same time, there are going to be cases where storing makes sense. For example, you must consider your tax situation which may force you to defer sales until a later date. You may also find that basis conditions in your area warrant further storage. I cannot account for every possibility in these examples, but this should give you the basis for further consideration.

As additional study, please answer the following questions about the last illustration we just went through on corn. 1. In the example of prices moving lower, what would the net realized selling price be assuming a cash sale date of June 15 and a price of $2.00?
2. In the example where prices went down and you used the option, what would have been your net realized selling price if cash corn would have been $2.00 on June 15?
3. In the example where prices increased, which would have been the better alternative if prices had gone to $3.00? $3.25?>BR? 4. Which example using the numbers given in our problem would have yielded the best realized selling price on June 15 had the cash market not moved and basis remained the same?

ANSWERS TO LESSON 9 ASSIGNMENT

1. What was the floor price established by purchasing the March $3.50 wheat put? (Hint: Strike price – options premium – commission)
$3.30 ($3.50 – 18 cents – 2 cents)
2. In the example where prices fell, would the farmer have been better off:
a. Selling the cash grain at harvest on July 15 would have been the most profitable strategy because the farmer would have realized the better price than storing the grain without an option and also would have received a higher price even then using options, as he would have saved the premium cost. Tax considerations, of course, could alter the answer to this problem.
3. If prices had risen after July 15 and gone to $4 on January 15, what price would the farmer have ended up with as his net realized selling price that day:
a. If he did not purchase any options, the net realized selling price would have been $4.00, but in this example we did not account for any cost of storage.
b. If he purchased the $3.50 put option, he would have realized $3.80, which is the $4.00 minus the cost of his option.
4. If the cash price on July 15 was $3.50 and was still $3.50 on January 15, would it have been worth buying a put option? There is no one answer to this question. The answer depends on many variables which are unique to each farming situation. Many farmers often ask us the question, is it worth buying a put option and that depends on such factors as your personal risk tolerance during the time period as well as the relative cost at that moment. Since there is no black and white answer, you must evaluate each decision on its own merit.
5. If the premium for the March $3.50 put would have been 21 cents, what would have been the floor price? $3.27 (3.50 – 21 – 2)
6. If instead of the $3.50 put the farmer would have purchased a $3.40 put at 14 cents, what would his floor price have been? The floor price would have been $3.24 (3.40 – 14 – 2)

SUMMARY

— Call options as a replacement hedge are an important marketing tool and a valuable component in a total marketing program.– The cost of the option must be balanced off against the cost of storage even when on-farm storage is used. — Other factors influencing the decision to sell cash and purchase a call option include tax considerations, cost of borrowed money, cost of lost interest and basis levels.– Good record keeping is important to maintain the deductibility of call option premiums for tax purposes.