CSU Ext: Using Call Options to Recapture Rising Prices
STERLING, CO – August 19, 2019 – Many corn produces developed very thoughtful marketing plans last winter that included pricing points at the $3.80 to $4.00 per bushel. These pricing points were established based on sound market outlook information at the time. Numerous producers forward priced their corn in late April and May only to watch the market rise in early June due to flooding and late planting in the corn belt.
Call options on the futures market are one tool producers can use to recapture rising prices. Call options provide the opportunity but not the obligation to buy a futures contract at a specific level (strike price). As the owner of a call option, you could also sell the option or let it expire if it has no value.
Let’s use the 2020 May corn futures contract as an example. At the writing of this article 2020 May corn futures were trading at $3.95/bu. Based on your observations you believe that the 2019 corn yields will be lower than are currently predicted and corn prices will be significantly higher next spring than the current $3.95/bu.
You review the options market on the Chicago Mercantile Exchange (CME) website and find that you can by $4.20 strike price for a premium of $0.14/bu. The $4.20 strike price is known as an “out of the money” position because the futures market is trading at $3.95 and the $4.20 call has no value with a $3.95 futures price. We normally look at purchasing out of the money options because the premiums are less costly.
A premium of $0.14/bu. would result in an investment of $700 per futures contract ($0.14 x 5000 bu.). Unlike a futures position, options do not require the establishment of a margin account and the possibility of margin calls. In this example the $700 per contract would be the only cash outlay.
Options trading terminates on the last Friday which precedes by at least two business days the last business day of the month prior to the contract month. The purchase of 2020 May call options would allow a corn producer to watch the May corn futures market until April 24, 2020.
The purchase of a call option will result in one of three possible outcomes. One outcome would be to exercise the call option and buy a futures contract at the strike price. Another outcome would be to offset the option and sell it to someone else, and the third outcome would to allow the option to expire. Let’s take a look how each of these outcomes might play out with our 2020 May corn $4.20 call option.
It’s now mid-April 2020 and the May corn futures contact is trading $4.60. Your call option will expire on April 24th and you think that the corn market may weaken in the next few days. Based on this information you call your broker and instruct her to exercise your option and to immediately offset the futures position.
You exercise your call option by buying a 2020 May corn futures contract at $4.20 (strike price). Your broker would immediately sell it at the current market price of $4.60 resulting in a $0.40/bu. profit. Subtracting the premium you paid when you bought the call ($0.40 -$0.14) would result in a net of $0.26/bu. or $1,300 per contract ($0.26 x 5000/bu.).
The calendar reads March 1st and 2020 May corn futures are trading at $4.60, you look at the CME website and note that May $4.20 calls premiums are priced at $0.45. Several weeks remain before the May option will expire (4/24/20) and many people think that the corn market will strengthen as we move into April. You have a nice profit locked in at $0.45/bu. and decide to offset your option.
You call your broker and instruct her to offset your call option and sell it. The option would be sold for $0.45, subtracting the premium of $0.14 would result in a profit of $0.31/bu. or $1,550 per contract.
In the final possible outcome takes place on Thursday, April 23, 2020. The 2020 May corn futures are trading at $4.10 and with your call, you have the opportunity to buy a May futures contract at $4.20. If you were to exercise the option you would buy a futures contract at $4.20 that is only worth $4.10 resulting in a $0.10/bu. loss. In addition no one would be willing to buy the call option from you. Given this scenario you would not need to call your broker, you would simply let the option expire. By allowing the option to expire you would have only lost your original premium of $0.14/bu. or $700 per contract.
In the examples above I have not included the brokerage fees that would be around 1 to 3 cents per bushel. It is also important to understand that futures and options trading involves substantial risk of loss and is not suitable for every producer.
If you have questions about this topic or any other agricultural business management issue, please feel free to contact me at 970-522-7207 or by email at brent.young@colostate.edu.