COTTON OPTIONS: BUYING PUTS
Let's say that four days ago, you watched cotton rally through a new high of 74.0 cents per pound only to sell off sharply and
close the day at the low. (See chart at right.) You interpret this as meaning that the initial spike was mostly
a response to outstanding buy stop orders just under the 74-cent level that were triggered but following that, there
was no new buying interest so prices collapsed. This has convinced you that cotton prices will move lower in the
future. The partial recovery since these events took place is giving you a good opportunity to short the market
at a favorable price and you are considering buying a cotton put option.
The first step of the
purchase decision
is to determine the maturity of the put option: it must be long enough to capture the anticipated price drop.
Since you suspect that prices will move lower over the next several months,
you decide that the
March 2010 cotton call options that
expire in
early February
are a good choice. The second step is determining the strike price.
March cotton put options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading Cotton Option Prices
Cotton options are priced
in cents per pound up to two decimals. One cotton option can be exercised into one
cotton no. 2 futures contract and since each contract is based on 50,000 pounds of cotton, the option price must be
multiplied by 500 to get a corresponding dollar value and every one cent change in the price of the option or the underlying
futures for that matter is worth $500 per contract.
For example, the March cotton put option struck at 73 (or 73.0 cents per pound) settled at 428 meaning 4.28 cents per pound.
The dollar value of this option is 4.28 x 500 = $2,140. This put option is nearly at-the-money
since the March futures contract settled the day at 72.67 cents per pound. Notice that the futures closed
higher over the day by 1.34 cents per pound pushing all put option prices lower but that the option prices moved by less
than this amount. In fact, this at-the-money put option fell by just 0.97 cents per pound.
As is evident in the table, as the strike price of a put option is raised,
its price increases
as does its sensitivity
to movements in the price of the underlying futures.
Choosing the Strike Price
This requires balancing risk with potential return. The former is simply the cost or purchase price of the option
along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $1,500
on a March cotton put option, then only those options having a strike price of 70 (or 70.0 cents per pound) or lower would be acceptable.
The potential return is based upon your expectation of how far cotton prices will fall. A useful reference is the
break-even price.
The break-even price of a put option
is calculated by subtracting the option cost and paid trading fees from the strike price.
Consider, for example, the March cotton put option struck at 70 (or 70.0 cents per pound). If it is purchased at
the settlement price shown, then the break-even
price of the March futures at option expiration is calculated as:
70.0 - 2.85 - fee value = 67.15 - fee value.
At option expiration, March cotton futures must be below this break-even price in order to
profit on the option trade.
So, you will only consider put options that have a break-even price above the price to which you expect
cotton will fall. Let's say, for example, that you believe March cotton can drop to 63.0 cents per pound by option expiration
which is an area of support seen in the chart above.
Based on this, you would only consider buying put options having a strike price of 65 (or 65.0 cents per pound) or higher since otherwise the break-even price
is too low.
What remains is the range of acceptable options. In this case, for an investment of at most $1,500 and with an expectation that March
cotton will fall to 63.0 cents per pound by option expiration, the put options having a strike price within the range of 65 to 70
would be acceptable to purchase.
After the purchase, you will need to manage the option position.
What if there are no remaining options that are acceptable after considering your desired risk and price expectation? Then you
can consider buying a more expensive put option and manage the risk, or
you can consider buying a bear put spread.
Bear Put Spread
When buying a bear put spread, both strike prices should be above the price to which
you anticipate the futures will fall by the time the options expire, in this case, 63.0 cents per pound. Based on this, there are several spreads
that can be purchased. For example, the 64/66 bear put spread has a value of 1.49 - 1.03 = 0.46 = $230 plus commission and fees.
If March cotton futures is below 64.0 cents per pound at the time of option expiration, then this spread will close
at its maximum value of $1,000 (calculated as 2 cents x $500 per cent). If cotton is above 66.0 cents per pound, then this spread will
expire worthless.
Stepping up the strike prices will increase marginally the cost of the spread, but the chance of the maximum value
being earned is greater since cotton need not fall so far. For example, the 66/68 bear put spread has a value
of 2.09 - 1.49 = 0.60 = $300 plus commission and fees. March cotton need only fall below 66.0 cents per pound at the time of option expiration
to earn the $1,000 maximum value of the spread. If cotton is above 68.0 cents per pound, then this spread will expire worthless.
As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater
potential payout by increasing the gap between the two strike prices. For example, the 64/68
bear put spread has a value of 2.09 - 1.03 = 1.06 = $530 plus commission and fees but the maximum value is $2,000
and will be earned if March cotton futures is below 64.0 cents per pound at the time of option expiration.
Because the market for option spreads is generally less active than the market for individual options,
you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase,
you will need to manage the option spread position.
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