Put Spreads

2017 SEASON — The market for the 2017 crop has started off a lot like 2016 and 2015.  Futures were at a sub-profitable level (see the blue line above) before the new year, so there was no good opportunity to meaningfully hedge a price that would cover all production expenses.   But the rally in Dec’17 futures that began in January raised the possibility to hedge prices that are worth protecting.  For example, on August 18, a 73 put option on Dec’17 cotton futures cost 6.37 per pound (the red line above).  Buying that 73 put implies a minimum cash price in low 60’s (depending on your basis), which may not be worth it.  Upside price potential is still open.  This strategy provides price protection that would likely cover typical operating costs (but not total costs) in Texas.  Still, it is not a trivial thing to pay over five cents a pound for such protection.  A cheaper version of this strategy would be to buy the 73 put and also sell a 66 put for 1.83 cents per pound.  That protects the futures downside between 73 and 66 cents, and this more target protection costs 6.37-1.83=4.54 cents per pound.  The path of that put spread is tracked by the green line above.  Is it worth 4.54 cents a pound to protect this range of prices?  Maybe, or maybe not.  That is something individual growers need to weigh for themselves.  Note:  These strategies are increasingly more expensive than in May because Dec’17 futures are lower since then.  That suggests the strategy might become more affordable if something unexpected rallies Dec’17 futures back over 73 cents.

Assuming a summer weather rally pushes Dec’17 all the way to 75 cents, I would consider a strategy at a higher strike price.   The graph below is an example of a 75:67 put spread.  On August 18, the 75 put option cost 8.12 cents and the 67 put cost 2.29 cents, implying a spread cost of 5.83 cents per pound.  The spread protects a futures price decline from 75 down to 67 cents, where the potential price protection is capped.   Again, the time to be shopping for these spread strategies is when the futures is trading at or above 75 cents — it is too expensive at the present time.  For educational hindsight, consider what the 75 put would be worth now had you bought it back in April or May when it was only four cents…



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