TOP FARMER INTELLIGENCE – Weekly Perspective by Bryan Doherty
WHY SELL CALL OPTIONS?
If someone were to say to you, I can offer an investment that has a fixed profit and unlimited risk, you would probably tell them you are not too interested. Yet, if they said, most of the time this investment is a winner, you might begin to reconsider. Now, if someone offered you a fixed profit and unlimited risk instrument, and you own the commodity that backs the instrument, you may now be intrigued. In other words, if the investment works against you, this means the commodity you own is gaining value. Sound complicated? It is and it isn’t. Let’s use an example that you can probably relate to.
You have corn in the bin. The price of your corn either goes up or down. If you were offered 10 cents per bushel to store corn for the next 90 days, you would probably ask what the catch is. The catch is that if the price of corn futures is above a certain level, you would be hedged (short futures at a higher price) 90 days from now. If corn futures are not above the higher level in 90 days, you gain the full 10 cents. By the way, if corn futures are above the certain level, you also gain the 10 cents.
Let’s apply some figures: You have corn in the bin and futures are trading at $3.80. You sell a $4.10 call for 10 cents. One of two events happen. Either corn prices 90 days from now are above $4.10, or they are not. If corn futures are not above $4.10, your corn in the bin is worth whatever the market price is. You, however, have gained 10 cents from the sale of the call option. If the price of corn is above $4.10, say $4.30, then your corn in the bin is hedged at $4.10 and you collect 10 cents, for the net price of $4.20 (less commissions and fees).
Most options, by mathematical definition, expire without value. The math is simple. The “certain level” referred to above is called the strike price. In corn futures, strike prices are listed every 10 cents. At expiration date, the last trading day for options, all call options above this strike price expire without value, and all put options below this strike price expire without value. This is what was referred to in the first paragraph. Most of the time, this investment (selling options on futures) is a winner. That is, the seller is able to buy back the option at a lower value, or it loses all its value by last trading day.
As a farmer who sells corn, if you believe the market can rally some (not a lot), selling an option and earning premium could be considered a win-win. You win by either collecting the premium at expiration, or your corn is hedged at a higher price and premium is collected. In the latter, corn prices probably moved higher than you thought. This, by many, would be termed a “good problem.”
Selling call options is not for everyone. There is margin required when the position is established, and additional margin required if the call option gains value. You should have an in-depth conversation with your advisor before entering this or any position, and a clear understanding of the associated risks.
If you have questions or comments, contact Top Farmer at 1-800-TOP-FARMER extension 129. Ask for Bryan Doherty.
Futures trading is not for everyone. The risk of loss in trading is substantial. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not necessarily indicative of future results.