Put Options for Down-Side Price Insurance Protection

In the chart above, as Dec’21 cotton futures (the blue line, above) rose since 2020, the premium for a 75 put option has gotten cheaper.  That is because the the put option gives the right to have sold Dec’21 futures at 75 cents, which had intrinsic value when the underlying futures was below 75 cents.  Put option premiums move opposite of the direction of the underlying futures price.  This is important because if the underlying futures, the increasing put option premium would potentially act as an insurance payment (assuming a stable cash basis).

Currently a 75 put option on Dec’21 only costs 0.13 cents per pound (as of September 23).  That implies a short futures position around 74.87 cent per pound (i.e., the 75 strike price less the 0.13 cent premium).  If you further subtract off your expected cash basis, the result is a minimum cash price floor in the lower 70s.  However, this is not the time to be thinking about implementing this kind of strategy since time is running out on out-of-the-money Dec’21 options.  They represent downside insurance protection on the 21 cotton prices that wasn’t needed (hopefully like most of your insurance policies).

A more relevant put option example is for the ’22 new crop.  Below is a similar chart of Dec’22 ICE cotton futures (blue line) plotted against the premium for a 80 put option on Dec’22.  Again, as the futures price has been mostly rising, the premium cost of an 80 strike price has been mostly falling.  As of September 23, buying an 80 cent put option for 6.76 cents gives a minimum cash price in the around 70 cents, with upside potential.  If Dec’22 futures continue to climb, the premium cost of an 80 cent put will become more affordable, and the associated minimum cash price will be higher.

 

 

 

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