Put Spreads

2017 Crop — 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 were worth protecting.  For example, during the spring and summer of 2017 there were several opportunities to buy an at-the-money 73 December put for around four cents (see the red line in the chart above).  Doing so would have implied a minimum cash price in lower/mid 60’s (depending on your basis), which may not be have been worth it.  Upside price potential would still have been open.  This strategy provided price protection that would likely cover typical operating costs (but not total costs) in Texas.  Still, it would not have been a trivial thing to pay four cents a pound for such protection.

Also back in the summer, a cheaper version of this strategy would have been to buy the 73 put and also sell a 66 put for a little over a cent.  That protected the futures downside between 73 and 66 cents, and this more target protection had a net premium cost of between two and three cents per pound back in the Spring.  The only relevant question for someone who had implemented this strategy is when to offset the position.  The value of that put spread is tracked by the green line above.   With the decline in Dec’17 futures since the summer, a put or put spread position would have increased in value, providing partial compensation for the declining cash value of unsold cotton.  With perfect hindsight, the spread position should have been offset in mid-October when it was worth over five cents.

2018 Crop — It is not too early to be thinking about, if not shopping for, affordable and relevant put spread strategies for the 2018 crop, as discussed here.  The graph below is an example of a 67:60 put spread.  In principle, the strategy works the same way as described above, i.e., protecting the range of futures prices between 67 and 60 cents. T he spread makes sense to “sell off” the put protection below a certain point since the loan rate (and eventually revenue insurance) provide downside price protection for deeper price declines.  With the rise in Dec’18 futures above 70 cents, the 67 and 60 cents puts have both gotten cheaper.  For example, as of December 14 the 67 put alone was 1.98 cents (down from 2.63 cents two weeks earlier), while the spread was 0.54 cents per pound.  This represents an opportunity to buy downside protection at a cheaper cost (or buy at a higher level for the same cost).  Remember that  there is nothing absolute about these particular option strike prices above.  I chose them for illustration purposes.  A grower would want to match them with 1) the cash price level at which cotton had been sold, 2) the level (and affordability) of prices to be insured.



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