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 June 22, a 73 put option on Dec’17 cotton futures cost 7.26 per pound (the red line above).  Buying that 73 put implies a minimum cash price around 60s cents (depending on your basis), which may or may not be worth it.  Upside price potential is still open.  This strategy provides price protection that would likely breakeven cost of production in Texas.  Still, it is not a trivial thing to pay over seven 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 2.81 cents per pound.  That protects the futures downside between 73 and 66 cents, and this more target protection costs 7.26-2.81=4.45 cents per pound.  The path of that put spread is tracked by the green line above.  Is it worth 4.45 cents a pound to protect this range of prices?  Perhaps 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 have been dropping.  That suggests the strategy might become more affordable if a weather market rally pushes 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 June 15, the 75 put option cost 8.89 cents and the 67 put cost 3.3 cents, implying a spread cost of 5.59 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.

Prices may not rise back to 73 or higher.  In which case, these examples are good for thinking about what you could have done had you implemented them in April or May and now had four or five cents of profit in them.  That profit represents your insurance payment against falling prices.



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