I’m sure many of you have heard different marketing gurus talking about selling grain and then buying a “call option”. As I discuss different trade strategies with producers, I find some of them interested in learning more about options. So I deemed the topic worthy of a blog entry. As you may recall, I wrote a blog on the Anatomy of an HTA as well if you would like to read it: http://www.cvacoop.com/blog/the-anatomy-of-an-hta/
I plan to keep it basic and only discuss the call option and how it works for a producer in the above scenario. First things first, what is a call option? The owner of a call option has the right to buy corn at the strike price. The purchaser pays a “premium” or fee for this option.
For example, a producer buys a $4.00 call option. This gives the producer the “Option” to buy corn at $4.00. If the market currently sits at $3.50, then the $4.00 call option is essentially worthless. Why? Who would pay $4.00 for corn when they can buy corn for $3.50. If the market was to rally to $5.00 and the producer has a $4.00 call option, that producer potential profits by $1.00 per bushel (minus premium and fees). The point here is that a call option is similar to buying back your corn but with no downside risk to speak of.
Let’s talk downside, by selling corn the producer locks in a floor, or bottom. The call option keeps your upside potential open. For example, if a producers sells his corn for $3.65 cash today and buys a $3.80 call option for 10 cent premium, the lowest price for that corn is $3.55 ($3.65-.10 premium). However, if the market rallies prior into option expiration, say to $4.50, the producer would have made approximately 70 cents (the difference between $3.80 call option and 4.50 market). Thus giving him $4.25 cash for his corn ($3.65 cash +.70 profit -.10 premium).
The premium of an option can be a bit confusing so here are some basics to understand how an option is valued. There are two factors in the price of an option, the intrinsic value and the time value.
Intrinsic value is the difference between the option value and the current market. For example, if December ’16 corn market price is $3.92 and you own a December $3.80 call option the intrinsic value is 12 cents. However, to purchase the $3.80 call option today would actually cost 35 cents. The additional 23 cents is the time value of the option. As expiration approaches, time value continues to proportionately erode.
In an effort to keep things simple, I have not gone into great detail. Our ProEdge team is available to answer your specific questions regarding options strategies. I will add producers without a brokerage account can still capitalize on this strategy by using ProEdge contracts.
For detailed trade strategies and recommendations check out our full client services at http://www.cvacoop.com/grain/proedge/