2018 Crop —As discussed in this article, the rally of Dec’18 cotton futures this year has made put option strategies both relevant and affordable.
The graph above shows a number of things. Dec’18 futures are reflected by the blue line (in cents per pound on the left hand scale). The red line tracks the value of a 85 cent put option on Dec’18, i.e., the right, but not the obligation, to have sold Dec’18 futures at 85 cents. Once purchased, that right would be increasingly valuable as Dec’18 futures declined toward/past 85 cents. In that way, an 85 put option is an insurance contract against a decline in the Dec’18 futures contract. The premium cost of this insurance is reflected by the red line (in cents per pound on the right hand scale). Since the put option gives the right, but not the obligation, to have a short futures position, it does not imply any margin exposure. The put option premium is the most one would be risking.
On Thursday June 28, the value of the 85 put option was 3.05 cents per pound. Buying this option implies a 85.00 – 3.05 = 81.95 cent short futures position. By further subtracting off your expected harvest time cash basis, you can identify the minimum cash price that you are insuring (somewhere in the mid 70s. If the futures and cash market were to rise, you would still be free to sell cash cotton at a higher price. So put options represent the simplest form of implementing a floor price while leaving the upside open.
There are further steps one can do to cheapen up and/or customize this type of price insurance. The chart above gives an example of this in the form of buying the 85 put option and selling an out-of-the-money put at 78 cents. Such a spread strategy implies no margin exposure, and it costs less than buying the put outright (see the green line above). However, it only protects the downside range of futures prices between 85 and 78 cents. For example, on July 12, the 78 put option traded for 0.94 cents per pound, so the net cost of a 85:78 bear put spread would be 3.05 – 0.94 = 2.11 cents per pound. Note that the choice of strike prices is arbitrary in this example. There are many different combinations of long and short puts that could be priced out here, depending on your risk tolerances and price outlook.
The hedging opportunities are obviously better as Dec’18 futures rise. So rallies in the futures market represent shopping opportunities for higher coverage levels with put options.