Hindsight tells us that in March 2001, cotton producers could have purchased a put option that would have helped them net 81 cents per pound for cotton 10 months later.
Keith Brown, speaking at the December Market Network teleconference, said that on March 1, cotton producers could have purchased a December put option with a strike price of 56 cents for three cents. Brown does a daily cotton broadcast on DTN.
Why March? “We usually recommend to producers that they buy these put options around the first week in March. And there's nothing magical about that. I'm sure there are many years when the market's higher and many years the market may be lower. But we just tend to look at March 1 as our trigger time.”
Anyone who bought the put option at that time was likely hoping that the option would expire worthless. “You don't want these put options to work,” Brown said. “Because if they do, it means the market has indeed taken an adverse turn.”
But last year, put options would have worked. The 56-cent put option — which is the right to sell a futures contract for 56 cents a pound — would have yielded a net 21 cents in December. Add a government payment of about 30 cents and a 30-cent cash market price and the net to the grower comes to 81 cents.
“Does that happen all of the time? No. But when it does happen, you are protected,” Brown said. “There are other years when the put options expire worthless because the market is higher, and there are some years that the put options expire even.
“At planting time, we want to maximize our profitability and we want to minimize our anxiety,” Brown said. “In the fall, we need to minimize our risk, and maximize our comfort level.”
Brown says one way to accomplish the latter is to sell cotton and buy call options, which confer the right to buy a futures contract at a specified price. “Sell your cotton,” Brown advises. “It really doesn't matter what the price is. And then you need to buy it back on paper. Buy the July call options. Then let the market do its job.” Could you do just as well to store your cotton?
Brown points out if you sell cotton and purchase a call option, you benefit if prices rise. But if prices fall, you're only out the cost of the option if they rise.
Compare that with storing your cotton where you could be out 25 to 30 cents if prices fall that far, plus the cost of storage. “Sometimes, it's losing less money that is the difference between a good marketing plan and not having one at all,” Brown said.
“How much better would it be for us to surrender four cents (the cost of the call) to the market than to ride the market down and lose 26 cents, 30 cents?” Brown asks.
As always, make sure you fully understand any option strategy you undertake.