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Strategy 2

Buy Put Financed By Selling Lower Value Put ("Put Spread")

Implemented (hypothetically) on March 15, 2005

West Texas Example:
This information is displayed as an example for educational purposes only.

NYBOT No. 2 Futures Contract :	Dec. 05
Futures Price (03/15/05 settlement; cents/lb)	58.000
Strike Price for Purchased Put Options (cents/lb)	57.000
Premium for Purchased Put Options (cents/lb)	4.450
Strike Price for Sold Put Options (cents/lb)	47.000
Premium for Sold Put Options (cents/lb)	1.050
Strike Price for Purchased Call Options (cents/lb)
Premium for Purchased Call Options (cents/lb)
Strike Price for Sold Call Options (cents/lb)
Premium for Sold Call Options (cents/lb)
Assumed Commissions (cents/lb)	0.0008
Assumed Local Basis (cents/lb)	7.000
Assumed** Harvest-Period Differential Between Futures & Adj. World Price (cents/lb)	8.000

Futures:	Local Cash Price (1)	Net Paid Premiums (2)	>Put Option Mkt. Value (3)	Call Option	Example LDP (4)	Total Net Price
44	37.00	3.400	10.00	n.a.	16.00	59.60
45	38.00	3.400	10.00	n.a.	15.00	59.60
46	39.00	3.400	10.00	n.a.	14.00	59.60
47	40.00	3.400	10.00	n.a.	13.00	59.60
48	41.00	3.400	9.00	n.a.	12.00	58.60
49	42.00	3.400	8.00	n.a.	11.00	57.60
50	43.00	3.400	7.00	n.a.	10.00	56.60
51	44.00	3.400	6.00	n.a.	9.00	55.60
52	45.00	3.400	5.00	n.a.	8.00	54.60
53	46.00	3.400	4.00	n.a.	7.00	53.60
54	47.00	3.400	3.00	n.a.	6.00	52.60
55	48.00	3.400	2.00	n.a.	5.00	51.60
56	49.00	3.400	1.00	n.a.	4.00	50.60
57	50.00	3.400	0.00	n.a.	3.00	49.60
58	51.00	3.400	0.00	n.a.	2.00	49.60
59	52.00	3.400	0.00	n.a.	1.00	49.60
60	53.00	3.400	0.00	n.a.	0.00	49.60
61	54.00	3.400	0.00	n.a.	0.00	50.60
62	55.00	3.400	0.00	n.a.	0.00	51.60
63	56.00	3.400	0.00	n.a.	0.00	52.60
64	57.00	3.400	0.00	n.a.	0.00	53.60
65	58.00	3.400	0.00	n.a.	0.00	54.60
66	59.00	3.400	0.00	n.a.	0.00	55.60
67	60.00	3.400	0.00	n.a.	0.00	56.60
68	61.00	3.400	0.00	n.a.	0.00	57.60
69	62.00	3.400	0.00	n.a.	0.00	58.60

Discussion

The put spread is one way to offset the premium associated with buying a put for downside price protection.

It retains the advantage of put options in setting a price floor (at purchased put strike price less the premium, less the basis) while allowing for you to take advantage of higher cash prices.

However, in this case, if futures fall below the *sold* put's strike, the latter becomes a liability. The effect of this causes your purchased put to "bottom out".

The LDP works on top of the put option in providing increasing (offsetting) income as prices fall below the low 50s.

Notes:

Local price is assumed to differ from futures by a constant basis. In reality, this differential is subject to possible "Basis risk" variations.
Premiums paid (less received) for bought (or sold) options.
These values are net of commissions. These values assume only intrinsic value for purchased options, which is realistic when the option is close to expiration, or when exercising into a futures position.
For illustrative purposes only, future LDP value is represented as a fixed 14-cents below the A-Index, which is assumed to be a fixed 7-cents above futures.In reality, the A-index can vary widely in relation to futures,and also vary to a lesser amount from the AWP.

At 44-cent futures, you could assume that the put option that you sold could e exercised, essentially putting you in the risky position of being in a long futures market position in a falling market. The negative value of this situation is reflected by a 1-cent loss in the Put Option Market value.

The Cotton Marketing Planner
http://agecon2.tamu.edu/people/faculty/robinson-john/

Dr. John R. C. Robinson
Associate Professor
Extension Economist-Cotton Marketing
Department of Agricultural Economics
Texas A&M University
2124 TAMU
College Station, TX 77843-2124
Phone: (979) 845-8011
Fax: (979) 845-4906
Email: jrcr@tamu.edu