Among the many strategies offered by marketing newsletters and advisors, "writing a covered call" is sometimes mentioned. What is a "covered call"? When they talk about writing a covered call, they are not talking about selling (writing) a special kind of option--they are actually referring to an option strategy.

The idea behind the "covered" call is to sell a call option when you own the commodity (stored grain, growing crop, etc.). Selling a call option results in an obligation to sell futures to the buyer of the call at the option strike price. Selling futures becomes a short position in the futures market subject to the associated risks of higher prices and margin requirements. However, ownership of the actual commodity "covers" (or offsets) these risks. If the option is exercised, this effectively results in a futures hedge at the option strike price where any losses (gains) in the futures market are offset or covered by gains (losses) in the cash market. It is sometimes described as "a hedge in reverse," since you would be backed into the hedge to cover the exercised call.

A key element of the strategy is to sell an out-of-the-money call option at a strike price where you are willing to start selling your crop. If the call is exercised, you are hedged at an acceptable price. If prices don't increase enough for the buyer to exercise the call option, the collected premium is simply used to enhance your cash price.

To illustrate a covered call, consider a new crop (2000) soybean example. Recently November soybeans have traded in an approximate range of $5.50 to $5.90. During this time, suppose you sold a $6.00 (strike price) November soybean call and collected a premium of about $0.35. What happens with various price scenarios?

November soybean futures price rises above $6.00. In this case, the buyer may exercise the option and you would be required to sell futures at $6.00. You would effectively be hedged at $6.00 since the growing crop "covers" the futures position. Assuming a harvest basis of about minus $0.35, your net cash price would be about $6.00 ($6.00 futures hedge minus $0.35 basis plus $0.35 option premium received = $6.00).

November futures price below $6.00. If the option expires, the premium you collected ($0.35) will enhance the net price received for your cash soybeans.

Cash soybean prices below CCC loan rate. The market loan adds another "wrinkle" to the covered call strategy. The loan rate establishes a price floor around $5.25 (depending upon county loan rate) using either the loan or LDP. This establishes a floor price near $5.60 ($5.25 approximate loan price plus $0.35 option premium).

The combination of a "covered call" and the market loan program, in the above example, allows protecting a price range of $5.60 to $6.00. This example illustrates how using a somewhat complex combination of marketing tools can build a strategy that locks-in profitable price in a risky market situation.  -- Melvin

Decisive Marketing - May 19, 2000
http://outreach.missouri.edu/agconnection/DCT/DM000519.html -- Revised: April 20, 2004
breesm@missouri.edu