A Conservative Marketing Strategy: The Bull Call Spread
As producers sell grain this winter, many are asking for a strategy to retain ownership. We’ll review some strategies in this perspective and focus on a conservative strategy that has merit when comparing it with the cost of storage and also reduces market risk. This strategy is called a bull call spread. Other strategies to retain ownership are buying futures or buying call options. You have plenty of choices, and you need to pick the right strategy that works for you.
Let’s first take a look at replacing grain by purchasing futures. This is done through a broker, and you are purchasing either the March, May, July, September, or December futures. July is technically the last old-crop contract that represents the 2016 crop. September is considered a new-crop contract, as is December. Futures are quite simple. From where you purchased, prices go up or down. Futures require initial margin as well as a maintenance margin, should the market move in a direction not in your favor. Initial margin is your down payment on the positions (usually 3% to 5% of the value of the entire contract). The initial margin is set by the exchange and changes as prices and volatility change. Many like to use futures because it can be a direct reownership. That is, when the market moves a penny upward, you gain a penny. Usually when farmers reown sold corn with futures, they accept the same market risk as stored corn. Often they are replacing those stored bushels because there was a reason to move actual inventory. Some examples may be cash needs, concerns of spoilage, and road postings, etc. Risk is unlimited.
Call options can also be purchased as a strategy to retain ownership. A call is a fixed-risk instrument that is purchased at a certain price level, called the strike price. Call options are often viewed much like insurance. You’ve sold the grain, and now you are buying the option (not the obligation) to buy back grain at your strike price if prices go higher (similar to an insurance policy). The price you pay for this option is called a premium, and is derived from time value, intrinsic value, volatility, and proximity to futures. Calls are a great way to retain ownership with a fixed risk. However, calls are also a wasting asset. If the market doesn't move much, time value chews away at them. Calls that are termed at-the-money (same strike as futures price when the call is purchased) may cost about the same as storage costs.
Probably the most conservative strategy is a bull call spread, where you purchase a call option in a particular month and sell a call option at a higher strike price in that month. We like to encourage bull call spreads for retained ownership as we are attempting to add value to cash sales, yet at the same time, reducing out-of-pocket expense compared with just buying a call. Cash sales are often made in anticipation of greater downside risk for prices. The bull call spread is subject to risk, yet often less than storage costs and less than the price of only buying a call. When you sell the out-of-the-money call, those premium dollars come back to you immediately and offset the cost of the lower strike price call that you are purchasing. The drawback to bull call spreads is they can be slow movers and have a fixed profit. Yet, from the view of buying a longer term window (spending money on time), the selling of time value on the out-of-the–money call can be a cost saver. This fixed risk position allows you to “stand” in front of the market for a long time. We suggest using September or December months for this strategy.
Make sure you understand the opportunities, risks, and costs associated with these tools before you enter into them. My examples do not include any commissions or fees. There are many tools available that will help you withstand the ups and downs of market volatility, and they may be well worth their cost.
If you have questions or comments, or would like help in creating a balanced strategy for your operation, contact Bryan at Top Farmer Intelligence (800-TOP-FARM, 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.
Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Hypothetical performance results have many inherent limitations. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. No representation is being made that scenario planning, strategy or discipline will guarantee success or profits. The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Reproduction of this information without prior written permission is prohibited. This material has been prepared by a sales or trading employee or agent of Stewart-Peterson and is, or is in the nature of, a solicitation. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Stewart-Peterson. Stewart-Peterson refers to Stewart-Peterson Group Inc. and Stewart-Peterson Inc. Stewart-Peterson Group Inc. is registered with the Commodity Futures Trading Commission (CFTC) as an introducing broker and is a member of National Futures Association. Stewart-Peterson Inc. is a publishing company. A customer may have relationships with both companies. Accordingly this email is sent on behalf of the company or companies providing the services discussed in the email.