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Call Options - a hedging alternative for variable demand

Once again, Australia is in the grip of drought and grain end users are faced with paying record prices for their grain requirements. What's different this year is the global supply and demand equation for wheat is very tight. The poor season here in Australia has followed poor crops and difficult harvests in the Northern Hemisphere. As a result, global prices are trading at record levels and now the Australian domestic market is trading at a premium which has been as much as $100 AUD per tonne above North American futures. Australian grain on the east coast is once again trading towards import parity.

Some grain end users do not know with complete certainty what their annual grain requirements are going to be because they operate a business that experiences variable demand and often transact based on spot market prices. Two examples of this are a lot feeder who runs a custom feeding operation and a stockfeed manufacturer. Both enterprises, to differing degrees, compete for business based on the cost of their feed ration.

The risk for such enterprises when considering hedging alternatives is that they do not want to be in a situation where their hedge is out of the money and therefore their ration cost is not competitive when compared with spot market prices. A common reaction to date has therefore been, "If the competition is not hedging then I do not hedge. If the market goes against me it also goes against my competition and we suffer together."

Is there a way to manage price risk without committing to a price?

End users with variable grain demands can protect their business from rising commodity prices without any obligation if prices trade lower. This is achieved by essentially insuring against a rally in the price of the commodity. Buying a call option achieves such a trading strategy.

A Call Option refers to the right to buy a futures contract at a certain price on or before a certain time in the future. When you call a real estate agent about their advertised apartment on the Sunshine Coast – you may well be trying to buy the apartment. When you buy a Call Option you are buying the right to buy the futures contract.

Similar to insurance, you are buying a right, not an obligation. When you insure your car, you reserve the right but not the obligation to have an accident in the next twelve months. When you protect the value of your grain inputs you reserve the right, not the obligation, to buy at a certain price. Importantly, because you are buying a right, if market prices trade lower you are free to take advantage of better prices. If you change your ration mix, you have no obligation to the market. What you do with the option is up to you. You can look to either sell back the bought option or let it lapse worthless or exercise if it is in the money at expiry.

When you buy the call option, like insurance, you pay what is called a premium. The premium is what the strategy costs, so you know the money you are putting at risk.

On the 27th August 2007, the January 2008 Milling Wheat 340 Call Option traded at $20. That is, the buyer of the call option reserved the right to buy January 2008 Milling Wheat at $340 NSW track. The cost of this option was $20 per tonne. On its own, $20 per tonne sounds like an expensive investment. However we need to look at what this strategy achieved.

Firstly, had the market traded lower, the most this strategy cost was the premium paid of $20. The option buyer would have been free to buy wheat at the cheaper market price. 

As we now know, the market traded higher. On Wednesday 26th September 2007, January 2008 Milling Wheat settled at $450. Allowing for the cost of the option, the option buyer has established a ceiling price of $360 NSW track ($340 + $20) for the wheat.

As you can see, what originally looked like an expensive strategy protected the end user from higher grain prices but also allowed participation in market downside if it were to occur. All of this was achieved with a limited investment risk. Had prices fallen, the risk was known at $20 per tonne. One question for custom feeders and stockfeed manufacturers is could the cost of an option strategy be absorbed during periods of low grain prices? Another question is would their customers be more or less inclined to establish long term supply agreements in the knowledge that the business is protected against drought inflated grain prices?

ASX Contract 27th August 2007 26th Sept 2007 Hedge Return
(AUD/tonne)
Final Result
Futures Hedge Buy Futures Sell Futures
AWM8F $349 $450

$101

($450-$349)

The final price paid for the grain will be $101 lower than the actual price paid for the grain. As the hedge return will offset the physical cost.
Call Option Hedge Buy Options Option Worth
AWM8F
340 Call
$20 $110
If price fell   $250 

$270

($250 +$20)

If prices fell below $340, the right to buy at $340 would not be exercised. Instead the end user is free to buy wheat at the prevailing market price. Assuming the market was trading $250, assuming the option was let to lapse worthless, the actual cost of the grain would be $270. This price is calculated by adding the premium paid ($20) to the actual purchase price ($250).

Price rose   $450

$360

($450-$90)

The right to buy at $340 would either be exercised and futures sold, or the option would be sold. The $90 profit from the option strategy would offset the cost of the physical. Using $450 as the physical price, the final result would be $360 = $450 less $90, the profit from the option.

Call options are available over the following ASX contracts; Milling Wheat, Feed Barley, Canola and Sorghum.

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