Call Option “Storage Hedge” Strategy

Another common hedging strategy for growers 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 85 cent Jul’21 call option premium (traced by the red line).  The call premiums tracks the movement of the underlying Jul’21 ICE cotton futures price (in blue).  As Jul’21 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:  the same logic applies to mill buyers who buy cotton on-call (i.e., fix the basis now and fix the futures price later).  These mill buyers probably expected the futures price to decline.  The purchase of a call option is insurance against rising prices.  Mill buyers can pencil out a maximum purchase price by adding together the call option strike price (85 cents per pound in the above example) plus their buying basis, e.g., 5 to 8 cents a pound, plus the call option premium cost (currently around 3.5 cents per pound).

 

Comments are closed.