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  • Hedging with options

    Chapter 4 - Cotton trading - Hedging and market systems 

     
     

    Some degree of price protection for growers and textile mills can be achieved by utilizing derivatives, or options, on futures. In 1984 NYCE first offered options on futures contracts. This action offered a whole new means of price protection for buyers and sellers of cotton. Options on futures are being used more and more around the world by both growers and textile mills. Generally merchants do not use options to hedge except to create a synthetic future which involves the buying and selling of options. However, merchants are, and should be, capable of incorporating options in contracts with growers and textile mills.

    There are two types of options on futures, call options and put options.

    Call options

    A call option gives the buyer of the option the right, but not the obligation, to a ‘long’ futures contract at a specific price for a given period of time. The seller of a call option has an obligation to deliver to the buyer a long futures contract, and must margin the call option in the same manner as a future contract.

    Put options

    A put option gives the buyer of the option the right, but not the obligation, to a ‘short’ futures contract at a specific price for a given period of time. The seller of a put option has an obligation to deliver to the buyer a short futures contract, and must margin the put option in the same manner as a future contract.

    Using options

     

    Call options and put options can be used to develop minimum price strategies for ginners or exporters and maximum price strategies for textile mills. The exporter and the textile mill do not have to trade the options directly. The merchant can incorporate them in the contract at the time of pricing either a fixed price or an on-call contract.

    Guaranteed minimum price contract

    Imagine a trader is offered a quantity of cotton by a grower but the grower does not want to fix the price of the cotton just yet. The grower may have reason to believe that prices will rise in the near future but not want to carry the cotton because of the charges involved. However, the grower wants some protection in case prices move downward instead. The trader could enter into a guaranteed minimum price contract in the following way.

    Assume that futures are trading at around 54.00 cents per pound and the grower agrees to sell the quantity of cotton to the trader at a basis of 4.00 cents per pound off futures. If the trader incorporates a put option in the basis he or she could guarantee the grower a minimum price for the cotton in the following manner. Assume a 50.00 cents per pound put strike premium costs 2.00 cents per pound. The trader buys a 50.00 cents per pound put option for 2.00 cents per pound for the grower which is added to the basis, resulting in a new basis of 6.00 cents per pound off futures. This strategy guarantees the grower a minimum price of 44.00 cents per pound no matter how low prices ultimately go.

    Say future prices go as low as 40.00 cents per pound and the grower decides to fix the price on the cotton which has already been invoiced to the trader. The price will be fixed at 34.00 cents per pound, 40.00 cents per pound minus the 6.00 cents per pound. However, the put option will have gained at least 10.00 cents per pound in value which will be credited to the grower. Add that to the 34.00 cents per pound the grower receives for the cotton, and that brings the price back up to the guaranteed minimum price of 44.00 cents per pound.

    If the futures market does go up as the grower thinks, the put will would expire worthless but the grower will have the opportunity to fix the cotton at the higher price.


    Guaranteed maximum price contract


    With a call option

    Example 1. A textile mill buyer enters into a contract with a merchant for cotton to be delivered during June and July. Everything in the contract is established except the price; an on-call contract. The basis price of the contract is 7.50 cents per pound on July New York futures, which are trading at 54.00 cents per pound. The cotton buyer does not think prices will rise much but wants some insurance in case prices do rise. The buyer elects to get the seller to incorporate a July 58.00 strike call option that is trading at 1.50 cents per pound. The buyer will then have a guaranteed maximum price of 67.00 cents per pound. Simply add the basis and the price of the call option together to establish a net basis of 9.00 cents per pound on July and add that to the call strike price to arrive at the maximum guaranteed price.

    Before the call option expires the July futures price rises to 66.00 cents per pound. The buyer decides to fix the price of the contract at that level. Add to the 66.00 cents per pound the net basis of 9.00 cents per pound to arrive at a fixed price of 75.00 cents per pound. Deduct the 8.00 cents per pound value of the July 58.00 call option to arrive at the guaranteed maximum contract price of 67.00 cents per pound.

    If futures prices go down, the buyer will have an opportunity to fix the contract at a lower price and the option will expire with no value.

    Example 2. A textile mill buyer enters into a contract with a merchant for cotton to be delivered during June and July. The basis price that the cotton was contracted at is 7.50 cents per pound on July New York futures, which are trading at 54.00 cents per pound, making the fixed price of the contract 61.50 cents per pound.

    The buyer does not think that prices will go down but wants some price insurance in case they do. The buyer decides to incorporate a July 50.00 strike ‘put option’ into the contract, at a cost of 1.50 cents per pound. The 1.50 cents are added to the buying basis, resulting in a net basis of 9.00 cents per pound on July futures. The fixed price of the contract is now 63.00 cents per pound, a guaranteed maximum price contract. Suppose that futures prices do in fact go down, to 44.00 cents per pound. The put option will now have a value of 6.00 cents per pound. The option will be closed out and the 6.00 cents would be rebated to the buyer, making the net price of the contract 57.00 cents per pound instead of 63.00 cents per pound.

    If prices do rise, then the buyer has the cotton bought at a price lower than the market.

    These are just two basic examples of how options on futures are used in order to gain some measure of price protection in what is usually a very volatile market. Most sellers of United States cotton will incorporate the cost of the option, called the premium, into the price of the contract, thereby saving buyers the time and trouble of making the option transaction themselves through a futures broker. However the strategy works the same regardless of the purchase method.

    The cost of the premium works the same as almost any insurance premium in that the cost depends on the amount of price protection, or insurance, the buyer wants. The greater the protection desired, the more costly the premium will be. 

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