This is a sample entry from John Payne’s newsletter, This Week in Grain, published on Tuesday, June 24, 2014.
Here is a hedge idea for anyone who is undersold corn, plans on selling into a bounce later in the summer, or just likes trading option spreads. I like this position for hedgers more than speculators because the corn a producer has in the field would be representing a long position on the board. That said, I think this could work for anyone who believes a corn bounce could be coming and they would like to sell into it. I love the idea of buying a July 4th bounce and selling it in early August. Think of this trade as a pollination risk play using a horizontal call debit spread.
My thinking goes like this:
Sell 1 August Corn call while simultaneously buying 1 September Corn call at the same strike. You can use whatever strike you prefer, the higher the strike the cheaper the initial debit will be. For this example, I am going to use 470 at current prices (Sep corn is at 434 as I write this at noon on June 24, 2014).
- Sell 1 August 470 call for 5 cents ($250)- expires July 25
- Buy 1 September 470 call for 8.5 cents ($425)- Expires Aug 22
- Total cost out of pocket will be 3.5 cents ($175 before fees)
August corn options expire July 25, September corn options expire on August 22. Both option prices are derived from September Corn futures. This is confusing for a lot of people and this article probably won’t make sense unless you keep that in mind.
What happens if market goes higher?
IF the corn market would rally back above 470 by the 25th of July and expire, the trader would be exercised on the short 470 August call option, turning it into a short September Corn futures contract marked from 470. That will represent a sale of 5000 bushels of corn for the producer (on the board/paper instead of a contract through a processor.) The beauty of this trade is that we would already own the September call, locking in losses above 470*.
Fast forwarding to September option expiration on August 22nd, if prices are above 470, the long call will expire in the money and turn into a long September corn futures contract, offsetting the short contract (from the short Aug call) we already have on the books. This would result in a net loss of the 3.5 cents we paid out initially (before fees). Now, this would be good for the producer because their grain will be above 470 as well. Hopefully, for the undersold producer, prices are well above 470 as their grain will have appreciated significantly at that point. If the market would sell off after the August call expired in the money, but the September call option does not, the producer would be appreciates gains from the sale of September corn (from the expired August option) in their futures account.
What happens if corn goes lower or never gets to 470?
It is important to understand this trade does not represent a hedge against prices going lower from here. If prices trade sideways or lower, the call options in August and September will both fall. If by the July 25th expiration of the August options, September corn futures are below 470, the August call we sold will expire worthless. That will leave a naked 470 long call still on the books for the next month until the September options expire. Producers can use the naked call in late July/August time period as a back stop or re-ownership strategy to cover sales they may be looking to make in August. Remember, the price on the spread was 3.5 cents, which would be the most the trader/producer could lose if prices would never see 470 again.*
This is just an example of a horizontal option spread. Every trader who works with me will tell you that I can design any option trade to fit their needs. I understand a lot of these strategies are difficult to comprehend through a written article like this, so I’m happy to explain more in detail over the phone at 866-825-8561 if needed.
*It is important to note that 3.5 cents (before fees) is the max risk of this ONLY on expiration. There could be a time, especially if prices would rocket above 470 before August options expire, where losses could be greater than 3.5 cents. But on September corn option expiration, wherever prices are above 470, the max loss would be 3.5 cents. I assume every single farmer in the world would take a loss of 3.5 cents in a futures account to have the opportunity to sell grain higher than 470.
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