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Corn+Soybean Digest

Cover It With Calls

The corn market soars to $2.50 cash in late spring. You forward contract or hedge much of your crop at that price. But a drought in July and August sends prices to $3. If you don't have a “what if” strategy in place, you're likely stuck with your contract price. It's not a bad price, but it could have been better.

The “bull-call spread,” a semi-sophisticated form of options trades, can help prevent lost revenue created by market increases, says Melvin Brees, University of Missouri extension economist.

Orville Williams, a southwestern Kansas corn, soybean, wheat and milo grower, leans on bull-call spreads and other options strategies to provide price protection.

“If I have sold some crop, I want to have a call in place,” says Williams, whose cell phone might ring several times a morning with calls from his commodity broker. “If I'm short the board (through selling a futures contract), I look at some sort of ‘cover’ protection.”

The bull-call spread is often recommended as a way to reduce call option premium costs when the calls are used to offset new-crop grain that's hedged or forwarded contracted for harvest delivery.

“A bull-call spread is accomplished by buying an at-the-money call option and selling an out-of-the-money call,” says Brees. “The at-the-money call provides the ‘insurance’ against missing higher prices. The premium collected from selling the out-of-the-money call offsets part of the premium for the purchased call — effectively reducing the net premium cost.”

In a spread strategy considered by Williams in November for re-ownership of corn, he looked at July 2004 calls when futures were about $2.40/bu. “I would buy a $2.40 July call for about 16¢, then sell a $3.10 July call for 5¢. For a cost of about a dime, I was able to establish a marketing window of $2.40-3.10.”

To protect unpriced corn, Williams established a put-call strategy, selling a July $3.10 call for 5¢ and purchasing a $2.40 put for 15¢. For a net cost of 10¢, Williams obtained a floor net future price of $2.30 with potential of capturing an additional 70¢.

“If you're selling and want re-ownership, you can buy options to give a defined cost,” says Williams.

For a new-crop corn strategy, Brees uses an example of a $2.50 December futures price in late spring. “Assuming a harvesttime basis of -30¢, new crop could likely be forward-contracted at about $2.20,” he says. “Purchasing a $2.50 December call option would likely require a premium cost of 20¢, resulting in a net harvest minimum cash price of about $2 ($2.20 cash contract minus 20¢ premium).

“To reduce the premium cost, a grower could sell a $3 December call for about 8¢. The net premium cost would now be 12¢ (20¢ purchased premium minus 8¢ collected premium). This would raise the minimum price to $2.08 ($2.20 cash contract minus 12¢ net option premium),” Brees says.

Williams works with a regional commodity consulting firm, Schwieterman Marketing, LLC, in Garden City, KS. His consultant, Bret Crotts, points out a way to possibly use bull-call spreads for soybean marketing.

If, for example, soybeans could be contracted at $5.50 for November '04 delivery, a wide bull-call spread window for higher prices could be established for less than 20¢/bu.

“In this case, you could buy a $6.40 November call for about 40¢, then sell a $7.20 November call for about 22¢,” says Crotts. “Cost of the spread is 18¢. And 18¢ for an 80¢ window is pretty good.”

The feared margin call is what often keeps growers from using straight futures trades or calls. If the price settles above the short-call option strike price, the holder is responsible for the difference.

“It's important to understand that a bull-call spread is a risk management strategy, not a risk elimination strategy,” says Brees. “Selling or writing a call option is also referred to as a short-call position and carries much the same upside price risk as a short futures position. While losses would be offset by the long (purchased) call, it requires being prepared for margin requirements. The more complex the strategy, the more important it is to understand how each component works.”

To avoid the potential for margin calls, Williams uses hedge-to-arrive programs. With such a program, growers can lock in futures prices with grain elevators. The elevators, in turn, handle futures trades.

He stresses flexibility as a must for any corn or bean marketing program, especially for growers with on-farm storage. “Too many growers give up too much,” he says. “They try to sell all at once. I sell out of the bin in increments. We all need to sell our grain just like an elevator does.”

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