Sell your cotton and buy calls. That's a strategy that has been successful time and time again, says Joe O'Neill, New York Board of Trade (NYBOT) senior vice president of marketing.
O'Neill has more than 30 years' experience in watching cotton markets and market strategies for the former New York Cotton Exchange, which became part of NYBOT in 1998.
He may have grown up in Manhattan (not the one in Kansas) and attended Manhattan College, but he has plowed through marketing strategies that can assist growers from West Texas to the Mississippi Delta and beyond.
From his New York financial district office, O'Neill has seen cotton trades take every path imaginable. And there are times like these when low cotton prices are the norm that he solidly recommends selling your cotton at harvest and buying call options.
“Rather than sitting on your cotton, paying storage and hoping prices go up, sell it and buy call options,” he suggests. “That is the strategy that has worked the best for the past 10 years. It's the most profitable strategy we have seen.”
With the most recent market of prices at or below the 52¢/lb. government loan rate, growers are depending on government payments. At loan price, growers with a cotton base in the government program can see 6¢ or more in added income through direct payments on 85% of their base. If they have a cotton base they could see up to 13¢/lb. more in counter-cyclical payments.
However, if a grower has call options in place, a spike in prices due to a crop shortage anywhere in the world or an increase in demand, the calls would help add to the bottom line.
For example, after harvest, if the July futures price is 56¢ and you buy a 56¢ call, the cost of the call is likely about 2-3¢/lb. If the July futures price spikes and shoots toward 68-70¢, then the value of the call will increase. That can add to your profit.
“You have upside potential and don't have to worry about the downside,” says O'Neill.
However, note that if the market doesn't increase, the grower will be out the money paid for the call option.
Over 10 years, from 1995-2005, the average premium cost of an at-the-money July call option purchased about six months in advance of the expiration date was 3.8¢/lb. Most premium costs were between 2.9¢ and 3.3¢. Two years, 1995-1996, saw the premium cost at about 5.5¢ due to short crop conditions, higher cotton prices and higher volatility.
Jackie Smith, Texas A&M University Extension economist in Lubbock, says volatility in the NYBOT cotton options has made their trading more costly.
“Using the option gives you a longer time for the market to go up,” he says. “It can get you into the time period where we have historically seen some price increases as we try to establish the next year's crop.
“But I think the typical volatility was 15% about 15 years ago. In the last few years we have had a lot of 18% volatility. From 15% to 18% can add almost a cent to an option's cost with 10-12 months of time remaining,” he says.
The cost of storage is about $2.50 /bale/month, or about ½¢/lb./month. So Smith recommends trying to hold the cost of an option to 3¢ for a six-months-out period. “More than that would make it cheaper to store the cotton for six months,” he says.