Put Spreads on Old and New Crop

2018 Crop —As discussed in this article, the relatively high trading range of ICE cotton futures this year has made put option strategies for old crop cotton both relevant and affordable.

The graph above shows a number of things.  Mar’19 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 Mar’19, i.e., the right, but not the obligation, to have sold Mar’19 futures at 85 cents.  Once purchased, that right got increasingly valuable as Mar’19 futures declined below 85 cents (which happened first in July and again in August — see the graph above).  In that way, an 85 put option is an insurance contract against a decline in the Mar’19 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 Friday February 8, Mar’19 cotton futures on the ICE settled at 72.55, down from 79.08 cents a pound over a month earlier. The value of a in-the-money 85 put option over that period rose from 7.00 cents per pound to 12.45 cents per pound.  Going back further in time, buying this 85 put option back on August 7 only cost 3.87 cents per pound, and implied a 85.00 – 3.87 = 81.13 cent short futures position.  By further subtracting off your expected harvest time cash basis, you could have identified back then the minimum cash price that you were insuring (somewhere in the mid to upper 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.  The price floor is effectively created by the rise in value of the put option as the underlying futures contract has declined.

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 75 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 75 cents.  For example, back on August 7, the 75 put option traded for 0.78 cents per pound, so the net cost of a 85:75 bear put spread was 3.87 – 0.78 = 3.09 cents per pound.  On February 8 this spread was worth its maximum value of ten cents per pound.  Note the choices of strike prices are 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.

In planning for new crop, on Thursday, February 14, the Dec’19 settled at 72.71 cents per pound, down from 77.48 on December 6.  A 75 put on Dec’19 cost 3.56 cents per pound on December 6, but the value had risen to 5.51 cents per pound by February 14.  The 75 put premium value on December 6 implied a short futures position at 71.44 cents per pound.  A 75:68 put spread on Dec’19 ICE cotton cost 2.40 cents per pound back on December 6 (the green line below), which would protect against the more limited risk of Dec’19 falling from 75 to 68 cents. Such a position held into early 2019 represents insurance against a decline in the base price of 2019 crop insurance policies. The premiums for this kind of insurance might become even more affordable during any brief rallies during the first quarter of 2019.

With the reported lack of forward contracting opportunities, and the structure of current farm programs, hedging with put options is one of the few available tools for growers to protect from large declines in new crop prices.




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