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 85 cent Jul’19 call option and a cheaper 85:90 Jul’19 call spread (traced by the green line).  The call premiums tracks the movement of the underlying Jul’19 ICE cotton futures price.  As Jul’19 futures rise, the value of Jul’18 call options increase.  On Thursday July 12, Jul’19 futures settled at 88.15 cents per pound.  The in-the-money 85 call premium was worth 8.15 cents per pound, while the out-of-the-money 90 call 5.96 cents.

There is nothing absolute about these particular option strike prices — I chose them for illustration purposes.  It would have made sense to buy the 85 call or put on this call spread when one had forward contracted cotton in the low to mid 80s.

 

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