Sell calls with closer time value, buy deferred, analyst says

The slump in the December corn market from $7.00 (Oct. 31) to $6.51-¹⁄₄ (Nov. 14) was reflective of harvest pressure and lack of exports. Since then, prices have recovered to the upper $6.60 level.

From the bigger picture perspective, prices continue to tread water, waiting for fundamental developments to gain direction.

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Historically, prices are high, and bearish traders will argue demand reduction. Increased production will eventually move prices in a downward direction. Bulls will argue that, despite a lack of friendly news, prices are holding well. Anything less than ideal crop prospects in South America or the Northern Hemisphere will put upward pressure on prices.

Farmers wishing to own corn on paper for potential weather events over the next year can do so by buying futures or call options. Futures require margin and, unless stops are used to manage risk, have unlimited loss potential.

Often, farmers sell cash to avoid the unlimited loss potential, so futures are not a likely tool in this case. If fixed risk is desired, then owning call options is a good alternative. If wanting longer-term ownership using July or December options, a potential negative is the amount of dollars to purchase calls due to time value.

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A consideration is using two options. Buy the deferred and sell a closer month where you collect the premium.

As an example (we will use prices as of this writing), buy a July $6.80 call for 35 cents. Sell a March 7.10 call for 11 cents. If the March $7.10 call loses all its value, you would have reduced the cost of the July 6.80 call by 31%, not including commission and fees in this example.

The risk with the March option is March corn futures trading above $7.10, where you could be exercised (owner of the call turns it into a long futures), and you are assigned a short futures at $7.10 with premium collected. Or you might buy back the short call at a loss.

However, the long $6.80 call in July can gain, likely mitigating risk. The exchange will likely require margin requirement on the short call based on account risk exposure, volatility, time, and the proximity of the short call strike price to the current futures price.

The point of this perspective is to pre-plan for potential market moves. Many scenarios can occur.

If a bullish case develops, prices can often reflect this in a quick manner. We have somewhat made the argument that the current outlook would suggest March futures will not be above $7.10 anytime soon.

Trying to buy call options when a market is rallying becomes that much more difficult, as emotions and higher volatility can drive option prices sharply higher. You may end up paying a lot more than you intended or not be in the market at all, despite your good intentions to purchase calls.

With any strategy, carefully consider the risks associated before entering the position. Ask critical questions to your advisor who can help guide you through the implementation process.

Editor's Note: If you have any questions on this Perspective, feel free to contact Bryan Doherty at Total Farm Marketing: 800-334-9779.