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Corn+Soybean Digest

Consider Vertical Call Option Spreads

Vertical call option spreads are a great alternative for growers who need to generate cash by selling soybeans early, and want to take advantage of price increases that might happen later in the year.

The big advantage is that, when you cash out of your soybeans early, ownership is replaced with a known risk. A negative factor is that you also limit your upside price potential.

In this article, I will explain the mechanics of call options and vertical call option spreads. I'll also point out the benefits and pitfalls of the latter and give examples of how it might work in three price scenarios.

Buying a call option gives you the right, but not the obligation, to own a futures contract. For example, if you buy a Chicago Board of Trade (CBOT) July soybean $7 call option for 40 cents/bu, you'll pay a $2,000 premium (40 cents/bu on a 5,000-bu contract is $2,000) for the right to be long at $7. If soybean futures rally to $9/bu, the $7 call option will be worth at least $10,000.

The individual or company selling the option gets the premium and has the obligation to give you a long futures position at $7/bu.

To turn this example into a call option spread, you then would sell a CBOT July soybean call at, say, $8/bu for a price of 16 cents/bu. You would have paid 24 cents/bu (40 cents minus 16 cents) for the right to make $1/bu.

The option prices used here are just examples. Option prices change daily as soybean prices change. They're sold in 25 cents increments, with the option premium cost declining with increasing distance from the current futures price.

Let's look at how a vertical call option spread might work under three price scenarios. In all of these examples, the brokerage cost of $60-80 per contract has not been added in. In late January of a major uptrend marketing year like 1996 or '97, a grower needs to generate cash from his soybeans. He prices 5,000 bu at $6.80/bu at his local elevator. He then buys the July CBOT soybean $7 call at 40 cents and sells the $8 call at 16 cents. Here's what happens: (see printed article for chart)

On May 20, he liquidates the spread by selling the call option that he bought and buying back the one that he sold. Selling the $8 call limited his gain to 74 cents/bu ($5,000), while the futures market gained $2.50/bu.

In late January of a major price-decline year, such as 1993 or '94, the grower sells 5,000 bu of cash soybeans and replaces them with a July CBOT $6.50-7.50 vertical call spread. The day he sells, the basis is 10 cents/bu, so he nets $6.40/bu. The cost of the $6.50 call is 36 cents/bu, and he sells the $7.50 call for 14 cents/bu. His position changes as follows: (see printed article for chart)

When he liquidates the spread on June 20, he gets no gain. However, the cash sale at $6.40 was the right move to make, even after the $1,100 options-market loss is deducted.

At about the same time in a year like 1995, when prices chopped sideways, the grower prices 5,000 bu of cash soybeans on a 10 cents basis and replaces them with a $5.50-6.50 call option. He buys the $5.50 call for 34 cents and sells the $6.50 call for 14 cents. His net cost is 20 cents/bu or $1,100. Though prices remain flat, he makes money. (See printed article for chart.)

He liquidates the $5.50 call for a 50 cents ($2,500) gain. Holding the call option spread made 30 cents/bu additional income (50 cents gain minus 20 cents cost) and saved five months of interest expense on money borrowed to plant the crop.

As these examples show, selling cash soybeans and replacing them with vertical call spreads does not always work. The big advantage is that it allows you to cash out of your soybeans and replace ownership with a known risk, while keeping the door open for higher prices.

This year, growers who sold cash soybeans and replaced them with vertical call spreads have bought back the short leg and now are completely open to higher prices, if and when values turn higher. If prices continue lower, the $6.80-7 net from earlier cash sales looks good.

This is a complex concept. Try it with part of your crop to see how it works. Every year growers sell cash beans early and buy back call options or call option spreads, they pay a lot less interest.

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