Keep it Simple

Options offer potential flexibility in cotton risk management, if you stick to the basics.

Part one
Keep it simple

Understanding basic tradeoffs simplifies options

Most simply, using cotton options is an analysis of tradeoffs. Specifically, is the opportunity to share in price gains while having protection from falling prices worth the costs of the strategy?

If you're looking to protect the price on cotton you're growing to sell, buying a put option is the simplest option strategy. Buying a put option gives you the right, but not the obligation, to sell the underlying cotton futures contract at a preset strike price. For that right, you pay a premium to the put option seller.

If prices rise after you buy the put, you can sell your cotton on the higher market. That's how you share in the upside gain. You'd be out the premium you paid for the put, which you could view as cost of price insurance.

But if cotton prices plummet, the premium on the put you own will rise. You'd sell your put back into the market and collect the higher premium. The lower cotton futures fall, the higher the premium on the put you own will rise. Adding the gain you capture on the put premium to your cash cotton selling price is how buying a put sets a price floor.

View as price insurance

If you buy a put option and prices rise odds are good that your put will expire worthless. You'll be out the premium you paid for it.

Feeding that premium into the market bothers some growers. That's why some people use the insurance analogy. You buy insurance on your pickup truck. But you don't go looking to have a wreck so as you can collect on your insurance. Rather, you hope things work out well, so you can avoid collecting on your insurance. Options work similarly for managing market price risk. They provide protection if a price wreck occurs. But you'd end better off with a solid market rally.

Part two
Simple option combination

Forward contract/buy call sets a floor yet preserves opportunity to gain

Some reasonably simple option strategies involve combinations of positions in the options and cash markets. One combination strategy that will let you set a price floor, yet share in upside gains is forward cash contracting and buying a call option.

The forward sale protects you from lower prices, but also caps your upside. Buying a call option will retain the right to gain after you make the forward cash sale.

Buying a call gives you the right, but not the obligation, to buy the underlying futures contract at a preset strike price. For that right, you pay a premium to the call option seller.

The price floor that you set with forward contract/buy call is much like the price floor you get by simply buying a put.

Tradeoff considerations

Whether to simply buy a put, forward contract and buy call, forward contract alone, or hold the cotton unpriced while waiting for more information to make marketing decisions involves several tradeoffs.

  • One is relative level of the two price floors of the strategies involving options.
  • Another is relative premiums for the put and the call of interest.
  • A third is basis you'd lock in with the forward contract vs. basis you'd eventually expect to get if you simply buy the put.
  • A fourth is how far and which direction you think prices might move.
  • A fifth is how firmly you believe a major price move will occur.

In response to spring 2008 market volatility, some merchants stopped offering forward contracts. That may make buying puts a better strategy.

Concerns among merchants over margining hedge positions associated with forward contracts results in wider basis on those contracts. That, too, may make buying puts a better play.

Part three
Synthetic put

Option strategy to share in price and basis gain

Selling futures combined with buying a call option gives a position much like a forward contract/buy call combination. You set a price floor, yet can share in upside gains. The sell futures/buy call strategy is sometimes called a synthetic put.

If you cash forward sell and buy call you lock in the basis for the cotton. If you sell futures and buy call you do not lock in the basis, just like simply buying a put does not lock in the basis. That's why sell futures/buy call is called a synthetic put.

Use if expect better basis

Whether or not to lock in the basis involves tradeoffs. If the basis offered on the forward contract is strong, you might be more inclined to contract and buy call. If you expect a better basis than offered on the forward contract, selling futures combined with buying the call may be a better choice. That's one tradeoff.

Here's another tradeoff. If you short futures you'll have to put up margin money. Contracting avoids tying up cash in margin. With equal basis, forward contract/buy call would be a better choice than sell futures/buy call.

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