Talk with any hedger and they’re sure to tell you about an experience with trading on margin. Margin is a good faith deposit that a hedger must have in their account in order to initiate a long or short futures position. For example, the margin on a corn contract is currently $2,362.00. This means that if you want to get into a corn futures position, your account must have at least $2,362.00. In order to maintain the position, a hedger must meet maintenance margin requirements. The maintenance margin requirement for corn is currently $1,750.00. This means that the value of the hedgers account must always be above $1,750.00 in order to maintain the corn futures contract. If the account value falls below $1,750.00, the hedger will be on a margin call. The hedger will need to either deposit enough money in the account to get back to the initial margin area ($2,362.00) or liquidate the position to meet the margin call. The hedger’s goal is to have their cash position hedged, so the logical decision is to meet the margin call and deposit funds into the account.
You can see how the above scenario can cause unneeded stress on a hedger. Luckily, hedgers have the option markets as an alternative to an outright futures hedge. This article will summarize how producers and users of commodities can purchase options for a margin free hedge. If you aren’t familiar with how purchasing options works, see a previous article I wrote here: Options on Futures: An Introduction to Buying Options.
Purchasing Options for Hedging
Purchasing options offers a margin free way to help roughly determine a price you will receive or pay for your commodity. The costs to do this will only include the premium paid for the option plus the commissions and fees. Purchasing an option for hedging has many of the same similarities of purchasing insurance on a vehicle. Think about it, when you purchase insurance on a vehicle, you’re required to pay a premium for a certain time period of coverage. The same applies to purchasing options on commodities. You select a delivery month and purchase an option by paying a premium for the option. The only money you have at risk is the amount paid for the option. If the market benefits your cash position, the option will expire worthless and you will be out the premium paid. The same applies to insurance on your vehicle. If you don’t need to use the insurance, the coverage for that time period expires and you will be out the premium you paid for coverage.
John the farmer has 200 acres of corn he’d like to hedge. Using an average of 150 bushels per acre, he expects he’ll have 30,000 bushels of corn to sell at harvest. Given the recent rise in prices in the corn market, he wants to lock in a bottom price he’ll receive for a percentage of his corn. He decides to hedge 50% of his crop, or 15,000 bushels. He decides that the bottom price he’d like to receive is roughly $5.60 per bushel. Since he will be selling his crop in October, he’ll need to use the December put options to hedge his position. December futures are currently trading at $6.76. Knowing that each put option represents the right to sell 5,000 bushels at a specified price; he knows he needs to purchase three options to achieve his hedge. Options are quoted in cents, with each cent representing $50. The current price for $6.00 puts is 40 cents, or $2,000 for each put. John purchases three $6.00 corn puts for a total of $6,000 plus commissions and fees on April 19th.
You might be wondering why John purchased $6.00 puts when his goal is to lock in a price of $5.60. The reason for this is that you have to find an option that will equal the price you are looking to receive after the cost of purchasing the option. With his goal being locking in $5.60 per bushel, he knows that by purchasing the $6.00 calls for 40 cents each he will be able to lock in a price of $5.60.
October is now here and the December corn futures price is $5.50. The $6.00 puts are now worth $3,500. Due to the time value left in the puts ($1,000), John decides to liquidate them instead of exercising them into futures positions (refer to the article linked above to refresh your memory on time value and intrinsic value).
$3,500 (Gain from liquidating option)
-2,000 (Amount paid per option)
$1,500 gain per option
x 3 options
$4,500 gain from hedging with options
-1,500 (10 cent loss per bushel in cash grain times 15,000 bushels)
$3,000 total gain
Due to the option still having time value left, John was actually able to receive $5.70 per bushel for his corn (3000/3 contract = $1000 gain per contract / $50 per cent = 20 cents + cash price of $5.50 = $5.70 per bushel). This is 10 cents higher than he initially was looking to receive for his corn.
Hedging with options is a great way to provide a margin free from of risk management. Simply figure out the price you would like to receive for what you produce, and find an option that helps you lock in that price after the price of the option is paid.