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 Jul’18 call option (premium traced by the red line, in cents per pound) and a cheaper 73:79 Jul’18 call spread (traced by the green line).  The call premium tracks the movement of the underlying Jul’18 ICE cotton futures price.  On Thursday December 14, the 73 call premium cost 5.72 cents per pound, while the 79 call was worth 2.71 cents.   The 73:79 call spread therefore costs 5.72-2.71=3.01 cents per pound.  The rising value of the 73 call and the call spread represents insurance against losing on a possible futures rally above one’s forwarded contracted price in the low 70s for the 2017 crop.

There is nothing absolute about these particular option strike prices — I chose them for illustration purposes.  A grower would want to match them with 1) the cash price level at which cotton had been sold, 2) the level (and affordability) of prices to be insured.

 

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