Question from reader: Can you explain to me what a vertical call strategy over long futures is? It's been a while since I have dealt with calls, puts, etc. We have to sell the rest of our 2008 harvest wheat and I am looking for some way to take advantage of any rise in the price of wheat.
Response: Vertical Call vs. Futures
First, let’s review futures. There is a margin on a futures contract, called the initial margin requirement, which is about $1,500 per day for corn. It can vary if the exchange believes volatility is rising and more protection is needed, as in today's market. The value of a 1-cent move is equal to $50. So today the corn market is up 15 cents; one futures trade would be up $750 per contract. And, if the market had been down 15 cents, one would have a $750 loss per contract. If one only has $1500 in their account, they would have a margin call for $750 and would be required to come up with that much money for their trading account to keep the long [bought] corn position. In summary, one has unlimited opportunity with this trade, but unlimited risk.
Let's say a vertical call strategy was bought yesterday. This means the nearby call was bought and the deferred call was sold [or received premium]. A trader is required to deposit the difference between the two strike prices.
For our example lets assume a $5.80 call is bought at 75 cents ($3,750) and at the same time an $8.00 call is sold for 28 cents ($1,400) for a net difference of 47 cents ($2,300). This means between now and the fall of 2009 one has the right to the benefit of a move between $5.80 and $8. If the position is held to the close of the contract on the last trading day, he/she would have a gross gain of $5.80 – $8.00 or $2.20 ($11,000). In our example, he/she had the $2,300 cost of the call strategy and the net return would be $8,700.
The disadvantage of the vertical call is one is renting the right to be long. For this he/she has to pay the premium of $2,300 for a worthless trade at this time. If the market does not rally, one loses the entire $2,300. When this right is accepted, one has the potential of a net $8,700 gain with “NO FURTHER MARGIN CALL RISK."
The futures contract gives one a modest entry cost with unlimited risk for unlimited reward. Many times it is the least expensive way to get into the market, but it can be the most emotional and have the highest cash flow to manage. While the vertical call normally has a higher initial cost and long-term can have a higher net cost, it allows one to have a "known" cost regardless of futures contract price activity.
BEFORE TRADING, ONE SHOULD BE AWARE THAT WITH POTENTIAL PROFITS THERE IS ALSO POTENTIAL FOR LOSSES, WHICH MAY BE VERY LARGE. YOU SHOULD READ THE “RISK DISCLOSURE STATEMENT” AND “OPTION DISCLOSURE STATEMENT” AND SHOULD UNDERSTAND THE RISKS BEFORE TRADING. COMMODITY TRADING MAY NOT BE SUITABLE FOR RECIPIENTS OF THIS PUBLICATION. THOSE ACTING ON THIS INFORMATION ARE RESPONSIBLE FOR THEIR OWN ACTIONS. ALTHOUGH EVERY REASONABLE ATTEMPT HAS BEEN MADE TO ENSURE THE ACCURACY OF THE INFORMATION PROVIDED, UTTERBACK MARKETING SERVICES INC. ASSUMES NO RESPONSIBILITY FOR ANY ERRORS OR OMISSIONS. ANY REPUBLICATION OR OTHER USE OF THIS INFORMATION AND THOUGHTS EXPRESSED HEREIN WITHOUT THE WRITTEN PERMISSION OF UTTERBACK MARKETING SERVICES INC. IS STRICTLY PROHIBITED. COPYRIGHT UTTERBACK MARKETING SERVICES INC. 2008.