Call Option “Storage Hedge” Strategy

Another common hedging strategy with options is to  fix the cash price (either with a forward contract, a pool contract, or a post-harvest spot contract) and then buy a call option.  Call options premiums (the red line below) increase in value with increases in the futures market price (the blue line below).  This is because the owner of a call option has the right, but not the obligation, to have bought the futures market at the call strike price.  Hence owning a call option represents insurance against selling your cash cotton and then missing out on a later price rally.  It is sometimes called a “storage hedge” because it is a substitute for storing your cotton for later sale.  This graph shows a 73 cent Dec’17 call option (premium traced by the red line, in cents per pound) and a cheaper 73:79 call spread on Dec’17 (traced by the green line).  The call premium tracks the movement of the underlying Dec’17 futures price.  On June 22, the 73 call premium cost 1.28 cents per pound, while the 79 call was worth 0.46 cents.  Therefore the call spread cost 1.28-0.46=0.82 cents per pound.

 

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