Put Spreads on New Crop

The chart above shows, in hindsight, how a put option with a mid-70s price coverage level (“strike price”) would have worked during 2019.  Such a put option position was meaningful and affordable back when Dec’19 futures (the blue line, above) were trading above the mid-70s.  In early November 2019, ICE Dec’19 futures (the blue line in the chart below) settled in the mid-60s.  Consequently, a 75 put on Dec’19 bought earlier in the year would have about ten cents of intrinsic value at expiration (because the put gives the right to have sold Dec’19 futures at 75 cents).  This gain in the option premium in late 2019 shows how put option premiums move opposite of the direction of the underlying futures price, and hence act as insurance against declines in futures and cash prices (assuming a stable cash basis). A 75:68 put spread represents a cheaper and more limited version of this downside price insurance.  If Dec’19 futures declines again towards 60 cents, this spread maxed out at seven cents per pound.  Such spreads thus represent a capped insurance benefit.

 The 2019 season was all about selling or hedging cotton prices while they were profitably high BEFORE the realization of downside price risk.  The 2020 season is the reverse. Dec’20 futures in the 60s are not at a profitable level for U.S. growers.  So it is more a matter of waiting for favorable fundamental developments and taking swift action later.  In terms of pricing insurance with Dec’20 put options, we need to wait until Dec’20 futures (the blue line below) rallies into the mid-70s so that the Dec’20 put premium (the red line) is trading for less than five cents.  Dec’20 futures may be volatile, under the influence of production and supply uncertainty (e.g., acres, weather, yield, etc.).  So the rallies may come and go, requiring nimble selling and hedging decisions.


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