A prevalent basis contained in many of these contracts appears to be 250 points (2.50 /Lb) under the December, 1997 contract. With the December, 1997 contract closing yesterday (November 13th) at 70.73 /Lb, the producer's first obvious alternative is to fix the price now at a net SC cash price of 68.23 /Lb (70.73 /Lb plus the -2.50 /Lb basis). If prices subsequently fall, the producer has already sold and is, thus, protected. But, if prices rise, many will tend to regret the decision to price at 68.23 /Lb (regardless of whether this fixed price results in a profit for the farm). So, we'll feel great if prices go down (local bragging rights), but bad if they go up.

"Rolling" as an alternative

An alternative to fixing the price now might be to "roll" the existing contract. Rolling maintains the basis however you're still exposed to futures price declines. A common attribute in these type contracts is that they may be rolled to the March futures (72.13 /Lb) on or near November 20th. If the producer chooses to roll the contract, it would convert to a 390 points under March contract with an extended pricing horizon until approximately February 15, 1998. This would be advantageous if prices (specifically the March 1998 futures) rise between now and February. For example, if March futures climb 10 /Lb to 82.13 /Lb in mid-February, then the producer would be able to price at 78.23 /Lb. Conversely, if March futures fall 10 /Lb to 62.13 /Lb in mid-February, then the producer would only receive 58.23 /Lb. Obviously, the main difficulty with this strategy is that there is no functional floor on the price of the producer's cotton. Great if prices go up; horrible if they go down.

Third Alternative: Selling Now & Buying a Call Option

What if we could eliminate most of the difficulties with the two strategies above yet keep the preferred attributes? If we sell now we eliminate the angst of prices declining in the future. But how do we benefit if prices rise in the future? Consider taking some of the proceeds from the sale and buying a call option. I like the July, 1998 call options for many reasons. First, the July, 1998 options cover a time period sufficiently long (until mid-June, 1998) for prices to rise (from increased exports or smaller 1998 crop prospects). Second, because the cotton market has been relatively "flat", volatilities and, thus, premiums are relatively low. At this writing a 76 /Lb July, 1998 Call option was trading for 208 points.

By selling at 68.13 /Lb and buying the July, 1998, 76 /Lb Call, the worst one would do in a falling market is settle for 66.05 /Lb (adjusted for commissions, etc.), regardless of how far down the market might fall. Should the market recover and rise to levels above 76 /Lb, the option would be worth at least 1 /Lb for every cent increase in the July futures above 76 /Lb. So if July, 1998 futures rose to, say, 85 /Lb between now and June, 1998, the call option would be worth at least 9 /Lb. One would then add the 9 /Lb to the previously established floor for a net price of 75.05 /Lb.

Summing it up

The Current sale of the cash cotton combined with the purchase of a deferred call option provides a floor you can count on with the ability to benefit if prices move higher later. Note, that if prices do fall, then the sale now would net the best price. If prices rise substantially between now & mid-February, then "rolling" would net the best price. But, If one knows for sure which direction the market will go from here, one would not need to farm, work for universities, or anything else. Since we don't know which way the winds of price change will blow, let's prepare to manage the risks regardless of future direction. Selling now and buying a call is an approach that may yield acceptable results for many operations, regardless of the direction of future price movement.

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updated 11/3/97