Marketing newsletters and advisors continue to offer a variety of strategies to manage price risk associated with the drought potential. One strategy, often suggested, is to purchase call options to offset new crop grain that is forwarded contracted for harvest delivery. The forward cash contract is used to lock in harvest price and basis. Buying call options provides the right to participate in a drought driven price rally. However, in volatile weather markets, call options can be expensive.

A bull call spread is often recommended as a way to reduce option premium costs. A bull call spread (also described as a vertical call spread) is accomplished by buying an at-the-money call option and selling (writing) an out-of-the-money call. 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. However, selling the out-of-the-money call also places an upper limit on price. If futures prices rise above the sold call strike price, margin money and/or performance would be required. At these price levels, losses on the sold call would offset gains on the purchased call.

Consider an example of this strategy using current (Thursday, 5-25-00) market prices. December corn futures closed near $2.50. Assuming a harvest time basis of minus $0.30, new crop could likely be forward contracted at about $2.20. Purchasing a $2.50 (strike price) December corn call option required a premium of $0.20 resulting in a net harvest minimum cash price of about $2.00 ($2.20 cash contract minus $0.20 premium).

To reduce the premium cost, selling (writing) a $3.00 December call collected about $0.08 premium. The net premium cost would now be $0.12 ($0.20 purchased premium minus $0.08 collected premium). This would raise the minimum price to $2.08 ($2.20 cash contract minus $0.12 net option premium).

Selling the $3.00 call reduces the net premium cost of the $2.50 call but gives up prices above $3.00. When December futures rise above $3.00, the sold call places an upper limit on cash price at about $2.58 ($3.00 strike price minus $0.30 basis minus $0.12 net premium cost). This creates a potential net cash price range of $2.08 to $2.58 if dry weather sends December futures above $2.50. With favorable weather, harvest time December futures below $2.50 results in the floor price of $2.08.

It is important to understand that a bull (vertical) call spread is a risk management strategy--not a risk elimination strategy! 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. It requires being prepared for margin requirements. The more complex the strategy, the more important it is to understand how each component works. -- Melvin

Decisive Marketing - May 26, 2000
http://outreach.missouri.edu/agconnection/DCT/DM000526.html -- Revised: April 20, 2004
breesm@missouri.edu