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Look for Valuable Strategies That Make Sense, Analyst Says
As summer marches on and a more refined expectation for this year’s crop develops, it may be worth looking for strategies that could add value. Specifically, we’ll address a scenario where prices continue in a sideways trend, anticipating that this trend could continue into the early winter months. A strategy called an option strangle may have merit and will be explored in this week’s Perspective.
A strangle strategy is when you either purchase out-of-the money calls and puts, or sell out-of-the money calls and puts. We’ll take a look at the short (selling) strangle. For example, as a grain producer, you may want to consider selling call options against grain that you will be storing. A short call can only gain value if the market rallies above the strike price. This would imply that grain in storage is increasing in value. Should prices rally, you will be assigned a short futures at the strike price. If you sell an out-of-the-money put, you’re anticipating that prices will stay at or above the sold strike price by the option expiration date. Should prices drop below the sold strike price, this short put will be exercised, and you’ll be assigned long futures at the strike price.
What happens with the premium? When you sell (short) options, the buyer pays the premium, and you (the seller) collect the premium.
What happens if the option is exercised? If the buyer of the option decides to exercise, the exchange will assign you the opposite futures position of the seller’s futures position. That means you will be assigned a short futures position for a call, and a long futures positions for a put. This happens automatically if, at expiration, the option is one tick or more in the money. The premium you collected when you sold the option is still yours.
An example (note that this example does not reflect commissions and fees). Let’s say you sold an out-of-the-money March 440 call for 10¢ and an out-of-the-money March 370 put for 10¢. The combined premium you collected is 20¢. Now, let’s say the market moved above 440, and the 440 call is exercised. You would be assigned a short futures at 440, and are hedged against grain you have in storage. If the market moves below 370, the 370 put would be exercised, you would be assigned a long futures at 370, and reown corn from previous sales. To calculate breakeven, consider the 20¢ premium you collected. That means your breakeven is either 350 or 460.
Should futures prices finish between these two strike prices by option expiration date (February 23), you’ll collect the 20¢, and neither option will be exercised.
Be sure you understand the risks in shorting options, as it is a marginable position. The exchange will require an initial margin, and likely maintenance margin if the option is in the money at any time. Therefore, you will need to cash flow this position. This is not the case when you buy an option, as the premium you pay becomes your risk. All strategies have some type of risk and cost, including a strategy to accept the market price at harvest. Make sure you have an understanding of how any strategy can work for or against you before initiating it.
If you have questions or comments, contact Top Farmer at 1-800-TOPFARM, ext. 129.
Futures trading is not for everyone. The risk of loss in trading is substantial. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not necessarily indicative of future results.