Projections suggest that world demand for cotton for the 2006-07 marketing year will total near 122 million bales. A combination of record world consumption and static production in 2006 should reduce inventories and the world stocks-to-use ratio will fall to around 38.5 percent.
If current estimates hold true, the world stocks-to-use ratio would be at the lowest level seen in the past decade. This scenario portends higher cotton prices.
Under the current farm program, higher market prices decrease government payments. Therefore, producers may have more marketing decisions to make than ever before.
For some producers, protecting the counter-cyclical payment may demand a new level of marketing knowledge — particularly in regard to options on futures.
Since the mid-1980s cotton growers have found options to be useful for protecting and adding to their farm incomes.
Options on futures can also be used to protect counter-cyclical payments. For example, when futures prices climb to near 58 cents and higher (basis the December or March contract), the average price received by producers could edge over the 52-cent benchmark for reducing the counter-cyclical payment.
Past relationships between futures and average monthly prices received are variable. But, prices received by producers tend to average around 5 to 7 cents less than futures prices for a given marketing year.
Given that assumption, a producer would need to purchase either a 58-cent December ’06 or March ’07 call option to protect the 2006-07 counter-cyclical payment. Purchasing a call option at this strike price will protect the counter-cyclical payment at its maximum value of 13.73 cents.
If the average U.S. farm price received for upland cotton averages 66 (65.73) cents the counter-cyclical payment equals zero.
At the time of this writing, December ’06 cotton futures were trading at 56.80. A 58-cent December ’06 call option could be purchased for 294 points or 2.94 cents per pound. Each day market prices increase closer to or move above the 58-cent futures price, the cost of fully protecting one’s counter-cyclical payment greatly increases.
It is not uncommon for at-the-money options on cotton futures to hover near 400 points 4 cents per pound).
The producer’s biggest challenge in protecting his counter-cyclical payment with a call option lies in forecasting upward price movement well in advance of a sustained price rally. As suggested by many cotton marketing experts, the best time to purchase out-of-the-money call options may be in a period in which prices are seasonally weak.
A producer may also want to consider selling (also referred to as writing) an option, so that the option premium is paid to him. Simultaneously buying and selling options (i.e., an options spread) can reduce option expenses while still providing some level of price protection.
However, there are risks to writing options that producers need to fully understand. With current supply and demand estimates indicating higher cotton prices, it is an excellent time to talk to a commodity broker about utilizing options on futures.
For additional information on option strategies, producers can also contact the state Extension risk management specialist in their areas.