Price hedging strategies using options
ECONOMIST AT GRAIN SA
A marketing strategy is a constantly evolving process. Each year will need different tools and techniques to protect against and benefit from price volatility. This article provides the basics of how options work to protect grains and oilseeds from price volatility.
An option is a contract whereby one party has the right, but not the obligation, to buy or sell the commodity at a predetermined price, at or before contract expiry. This contract or option gives the buyer the right, but not the obligation to exercise the contract, while the seller of the option has the obligation to honour the contract if the contract holder wants to exercise it. Options can be bought through a broker on Safex. There are two types of options, put and call options.
When an individual expects a futures contract to increase, they can purchase a call option that gives the holder an option to purchase the futures contract at a specific fixed price within a specified time frame. This fixed price is known as the ‘strike price’. If the futures contract price increases above the strike price, the holder will make a profit.
A put option is the opposite. An individual who expects the futures contract to decrease from its current price in a specified time frame can purchase a put option. This put option enables the holder to sell the futures contract at a specified ‘strike price’. If the futures contract price then declines below the strike price, the holder will make a profit. This strategy can be used before or after harvesting to protect the value of grain growing in the field or the value of grain in storage.
It is easier to buy and sell options when there are higher levels of open interest and volume. The price of options depends on the intrinsic value, implied volatility and the period before contract expiration.
- Implied volatility measures the likelihood that the contract price will change.
- Intrinsic value is the difference between the underlying asset (WMZ Dec’21) and the strike price of the options contract.
- The time affects the price when ‘out of the money’ options are very low when close to expiry due to the unlikelihood of the underlying asset ever reaching the strike price.
Marketing strategies depend on an individual’s appetite for risk. Some disadvantages are that options may contain basis risks or include possible higher costs and require lots of data due to several options on each futures contract. Each marketing strategy demands knowledge of both the underlying market and options contracts to better protect against unforeseen circumstances.
Publication: September 2021