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 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 September 20, Jul’19 futures settled at 80.29 cents per pound, which is more than two cents lower than one week before.  The out-of-the-money 85 call premium was worth 3.07 cents per pound (down from 4.37 cents per pound one week before), while the out-of-the-money 90 call cost 1.93 cents (up from 2.91 cents one week before).  Hence, the net premium for the 85:90 call spread was 3.07-1.93=1.14 cents per pound.

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 call spread when/if one had forward contracted cotton in the low to mid 80s.

 

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