Content ID

255520

Cost Reducer or Covered Hedge?

A strategy for corn producers to consider this marketing season is the sale of short-dated July corn calls and purchase of traditional (long-dated) corn calls. We will outline in this Perspective the implementation and rationale behind this strategy.
 
Let’s first provide details about short-dated options. Shorted-dated options were introduced by the Chicago Board of Trade just a few years ago. They provide buyers and sellers alternatives that did not exist before, as these options expire sooner, and are less expensive.
 
The underlying futures is December for any corn short-dated option. The difference is its expiration date.  As an example, a traditional December 2017 corn option (also referred to as long-dated) has an expiration date of November 24, 2017. If exercised, the traditional option is converted into a December 2017 futures position.  A July 2017 short-dated option expires June 24, 2017. If exercised, it is converted into a December 2017 futures position (not July).
 
Farmers will buy traditional call options to provide the right (not the obligation) to own corn. They like the upward price participation, especially when dry weather can affect yield, most often in July and August. Often, they have already sold corn (forward contracted or hedged with futures), or they are intending to sell on a price rally. The bought call allows them to retain ownership of corn with a fixed risk. Calls are often thought of as a catalyst to help farmers maintain the discipline to forward contract or hedge, especially in markets where changes in weather forecasts can often have producers second-guessing their decisions.
 
One drawback to purchasing traditional calls is the cost of time. Time value is a pricing component of options. Most producers realize the need to own traditional calls to get them through critical summer weather, and they can be expensive. With the introduction of short-dated calls, there are new opportunities, as the options cover less time, and are less expensive. One strategy that currently looks attractive is to sell July short-dated out-of-the-money calls and buy out-of-the-money traditional calls. If futures prices stall, or don't rally up to the short-dated strike, all premium is collected, and the cost of the tradition call is reduced.
 
Here is an example: Sell short-dated July $4.20 calls for near 12¢ and buy long-dated December $4.20 calls for near 24¢. One of two things will happen come June 24 (when the short-dated July call expires). December futures will be either below $4.20 or above $4.20. If below $4.20, the short-dated call loses all its value and expires worthless. If above $4.20, the short-dated call is exercised. If it loses all its value, you will have effectively reduced your long call cost by 12¢ (less commission). If December futures is above $4.20, the call will be exercised, and you will be assigned a short December futures position at $4.20. With the 12¢ collected for premium, you will effectively be short corn at $4.32 December futures with a long $4.20 call covering this position.
 
In either case, you could be in a strong position. Either you reduce the cost of the long call by the end of June, or you will be hedged higher than where the market is priced today, with the long call that is still able to participate in upward price movement.
 
As always, before you enter into this strategy, be sure you understand the risks and rewards, and how it will affect your overall goals. 
 
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.

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