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 also a substitute/compensation for storing your cotton for later cash sale (or for putting it in the CCC loan for later sale).

This graph above shows a 65 cent Jul’20 call option premium (traced by the red line) and a cheaper 65:75 Jul’20 call spread (the green line).  The call premiums tracks the movement of the underlying Jul’20 ICE cotton futures price (in blue).  As Jul’20 futures rise or fall, the value of Jul’20 call options  increases or decreases, respectively.

In a hedging sense, call option strategies for growers are insurance against missing out on a later rally in prices.  Call option strategies therefore make sense when combined with cotton that has been cash contracted (either forward or post harvest).  Note that cash prices in 2019 got low enough in early September for positive Loan Deficiency payment rates.   Hence growers should pay attention to weekly LDP rates and consider preserving their beneficial interest in 2019 bales that they are also preparing to sell (i.e., forgoing putting the cotton in the loan).  See the last paragraph of this article for more discussion.

 

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