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 above shows a 85 cent Jul’19 call option premium (traced by the red line) and a cheaper 85:90 Jul’19 call spread (the green line).  The call premiums tracks the movement of the underlying Jul’19 ICE cotton futures price (in blue).  As Jul’19 futures rise, the value of Jul’19 call options increase.  On Thursday December 6, Jul’19 futures settled at 81.12 cents per pound.  An out-of-the-money 85 call premium was worth 3.21 cents per pound, while a further out-of-the-money 90 cent call was 2.01 cents.  The net premium for the 85:90 call spread was 3.21-2.01=1.20 cents per pound on December 6.

In hindsight, it would have made sense to buy the 85 call or call spread when/if one had forward contracted cotton in the low to mid 80s during 2018. But looking back from today, these call option values have declined along with the decline in Jul’19 futures (settling at 77.24 cents per pound, as of April 12).  This is an example of an insurance policy that simply did was not needed, i.e., there was no rally to miss out on.

Note:  2019 bales that are being forward contracted now could be similarly combined with near-the-money call options on Dec’19, Mar’20, May’20, or Jul’20 futures (depending on the cost).

 

 

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