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.  Since Jul’18 futures have risen over the last week, the value of Jul’18 call options has increased as well.  On Thursday March 8, the 73 call premium was worth 11.91 cents per pound, while the lesser-in-the-money 79 call was worth 7.01 cents.   The 73:79 call spread therefore costs 11.91-7.01=4.90 cents per pound.  If Jul’18 continues to rise further into the eighties and stay there, the value of this spread would max out at six cents.  So it is only partial insurance coverage since futures rose beyond the level that I originally expected, i.e., 79 cents.  In hindsight, what this example shows is is how this insurance would have worked if the position had been put on back in early to mid November.  It is not a recommendation of what to do right now.

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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