Time to look at call options

26 Jul, 2000 03:01 PM

ONE of the hidden costs of the current single desk arrangements for wheat are the very poor forward prices offered to Australian wheatgrowers. Although the national pool might generate returns above, or well within -$10/tonne, of closing December futures prices, forward prices rarely get anywhere near this, and can be discounted as much as $35/t under December futures. The difference between US futures prices and the Australian price is called the basis. Some growers are trying to work around the massive penalty imposed in the forward markets by selling their wheat using basis contracts where the basis does not need to be locked in. The AWB version of this is their basis pool contract. Other buyers have a cash basis contract so that payment is received in full at delivery, but where the basis can be locked in at a time when the penalties are not so severe. For those dealing just with forward cash prices, it is more difficult to avoid the penalty. When US futures are at their highest, and/or the dollar is at its lowest, we tend to get offered the better forward prices. When the dollar lifts, or futures fall away, we tend to get offered the best basis. One strategy is to chase the basis in the early part of the season, picking off those few days when the forward prices do not move exactly as expected, allowing the penalty in the forward markets to be reduced. They then wait until US futures fall away and buy call options to go against those sales. If the market rises later in the season, then the call options lift the value of the forward contract. So, selling wheat forward, and buying call options later on, normally during the seasonal low in wheat prices, has been a popular way of putting some price protection in place (that is, the final return can never fall below the forward price less the cost of the option), while overcoming the price penalty put in place by just taking out a forward contract. Some times it works and sometimes it does not. The main impediment is the up-front cost of the option, which has the potential to erode away the potential gains of the strategy. This becomes particularly so if the wheat market continues to fall through the year as it did last year, or if the rally later in the year is relatively small. We are now at the time of the year when buying call options would normally be considered. The market is currently at a low level, and has just fallen sharply. The US harvest is well advanced, meaning that supply pressures on the market should begin to lessen. Call options will only be needed by those who have forward priced wheat at price levels which may not look attractive at harvest time. The trick is to minimise the costs of the options. One approach might be to buy call options at strike prices close to the current market, and sell call options at higher strike prices. The effect of this is to minimise the cost of the options, but it does limit the potential gains. Growers needing call options should contact their futures advisers for a suitable strategy.


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