Cotton growers haven't been rushing to use futures or options because they already have a floor provided by the government program.

But with the potential for tighter supplies and higher prices, knowing the best time to secure a floor price could mean a better bottom line.

On average, January, February and March appear to be the best months to buy December put options, says Olga Massa, Clemson University assistant professor of applied economics. She bases her assumption on the study of 16 years of data that analyze the December futures price, the cost of options or their premium and variables that impact those costs.

“Put options are designed to enable producers to set a floor price and leave the upside open,” she says. “The only bad thing about them is they're not free.”

Among the variables that impact option prices are the current futures price, and the options strike price. Strike prices that are higher than futures prices are in-the-money and will cost more. Prices below the futures price are out-of-the-money and will normally cost less because they provide less price insurance.

For example, a strike price of 60¢ on a 60¢ futures price could easily cost 3¢/lb. in premium. But a 56¢ strike price might cost 1¢.

“Producers need the best price insurance opportunity for the smallest premium,” says Massa. “The price floor is set at the strike price minus the premium. Thus, in the above example, the price floor will be set at 57¢ with the 60¢ strike and at 55¢ with 56¢ strike. Usually, the best price floor can be found using near-the-money but not in-the-money options.”

Option premiums are also directly affected by volatility. In looking at the period between January and October of the December contract over the last 16 years, on average volatility is lower early in the year, which can help hold premium costs down. Volatility is highest during the growing season when weather and other factors can impact production. World supply-and-demand trends and export demand can also impact volatility.

Another rule of thumb is, like with car insurance, the more distant the time to maturity, the higher the premium cost. So time to maturity and volatility must be weighed against the time of the year with the highest futures price.

“We find that the average December cotton futures over the last 16 years peak slightly in March,” the Clemson economist says. “So when you combine the high average futures price, volatility and time to maturity, March could be the best time to buy a December put option.”

Of course, market prices are sometimes impacted by unexpected factors, like large fund trading and weather around the world. If, for instance, the December 2008 futures price shoots up due to drought in other major producing areas, then the best time to buy a put might be a year or more before the contract matures.

Or if by chance a cold, damp fall causes major harvest problems in the U.S., nearby futures prices might increase, opening new opportunities to buy puts.

John Robinson, Texas A&M cotton marketing specialist, says recent history provides examples of how different price patterns can be approached with the flexibility offered by options strategies over straight futures.

“The first was the December 2003 contract, when an unexpected late-season price surge highlighted the need for upside price flexibility in a marketing strategy,” says Robinson.

“The second example highlights the need for a price floor when you have a reasonable expectation of a major price decline, as in the December 2004 contract when futures dropped from over 70¢ (earlier in the year) to below 50¢ at harvest.”

Other examples are from December 2005 and 2006, when prices traded in a narrow band below most growers' costs of production. “In this situation, insuring a meaningful price floor using put options would have been more expensive, so various spread strategies could have been employed to finance the core put option strategy,”says Robinson.

Few things have caused a spike in the market lately. That could change with the world supply and demand situation, says Carl Anderson, another Texas A&M cotton economist.

“Although slow exports and increasing stocks have depressed U.S. prices, consumption worldwide has outpaced production for the last two years,” says Anderson. “And another shortfall is expected for the 2007-08 season.

“A three-year drawdown in stocks should be ample enough to push ‘A’ index (international) prices into the mid-60¢ range the second half of 2007,” he adds.

Anderson says that overall, the 2007-2008 crop “could be the turning point for higher prices. Growing populations and increased per-capita income in foreign countries are expected to push demand upward.”

The factor that has impacted corn and soybean prices the most the past year — ethanol production — could ultimately be what pulls cotton out of the doldrums. Many farmers are growing more corn and less cotton this year. With up to a 25% (4 million acres) or more reduction in U.S. cotton acres, supplies could become tighter.

World planted acres are also supposed to be down this year. But world production is still expected to increase some 400,000 bales, climbing to 117 million bales. “However, world consumption is expected to increase 3.7 million bales, climbing to 125 million bales,” says O.A. Cleveland, Mississippi State cotton marketing economist.

“Thus, the world production-consumption gap is forecast to be 8 million bales. Such a gap taken by itself suggests a strong price increase. Yet, for now, while a price increase is likely in store for 2007-2008 world cotton prices, the increase above 2006-2007 prices will be limited due to the large world carryover facing the market,” he says.

“World carryover is expected to decline only 3.5 million bales, down to 49.4 million. A 50-million-bale carryover represents a 40% stocks-to-use ratio, a bit high to allow a significant price increase,” Cleveland says.

Robinson says southwestern U.S. growers might be more reluctant to shift acres to grains. “It will vary by region and from farm to farm,” he says. “While the simple budget/breakeven comparisons strongly favor the alternative crops, a number of things should prevent large scale switching out of cotton.”

For more on the use of put options and other marketing tools and strategies for cotton, go to http://agecon2.tamu.edu/people/faculty/robinson-john/basic.html.