A “call spread” is buying a call at one strike and selling another call at a different strike (in most cases, the sell strike will be higher than the buy strike). In this example the producer makes a cash sale at $5.00/bu. and buys a $5.50 – $6.50 (buys the $5.50 call and sells the $6.50 call) call spread for a cost of $0.14/bushel. As with long only calls, the most that the buyer in this example can lose is the money spent to buy the call spread…in this example, $0.14/bu.
Scenario #1: Prices go higher.
In this example, futures prices turned higher ending at $7.65/bu. Since the futures price is above the call strike price, the buyer WILL convert to a long future position at a price of $5.50 (call strike price) and the buyer of the $6.50 call will also convert to a futures position.
The entire position results in a net price of $5.86/bu. (plus basis). The producer sold futures or cash corn at $5.00 and made and additional $0.86/bu ($6.50-$5.50 – $0.14 cost) in the call spread.
Scenario #2: Prices go lower.
In this example, futures price turned lower and ended at $3.65/bu. Since the price is below the strike price of $5.50/bu.the buyer WILL NOT convert the call option into a long futures position. Instead the call spread will simply expire.
The entire position results in a net price of $4.86/bu. (plus basis). The producer sold cash corn at $5.00 and lost $0.14/bu. on the call spread.