The Upside of Options
Futures trading on cotton began in New York in 1870 as a response to the price risk inherent in a physical contract during its six weeks shipment across the Atlantic. Today, the Cotton No. 2 contract traded on ICE Futures U.S. continues to serve the primary functions of price discovery and risk transfer for the global cotton market.
May 1, 2012
By Ben Jackson
Chief Operating Officer, ICE Futures U.S.
Futures trading on cotton began in New York in 1870 as a response to the price risk inherent in a physical contract during its six weeks shipment across the Atlantic. Today, the Cotton No. 2 contract traded on ICE Futures U.S. continues to serve the primary functions of price discovery and risk transfer for the global cotton market. And contract sanctity – the certainty that obligations will honored – remains a cornerstone of exchange trading.
In 1984, the exchange introduced options on cotton futures. Options provide the buyer with the right, but not the obligation, to go long or short underlying futures at the strike price by the options contract’s expiration date.
Options are an additional tool for market participants to take a position on, or hedge risk in, cotton futures. Speculative market participants who expect the market to rise can buy a call option, sell a put option or execute any number of spread trades tailored to their specific price view and risk tolerance.
Hedge participants who are “long” cash cotton and who fear declining prices can manage their risk by buying a put option, selling a call option or transacting a different set of spread trades.
In short, cotton futures contracts are not the only exchange-traded hedging tool. Options also can be very effective in managing risks in off-exchange cash/physical markets.
A major issue the cotton industry in 2011 was defaults in the cash market. After fixing sales at lower prices, some growers got sellers’ remorse and reneged on commitments to merchants when cotton prices went up. Some mills got buyers’ remorse after fixing sales too soon at the high, and then rescinded purchase commitments after prices declined.
Minimize Risk, Maximize Potential
As a risk management tool, options allow cash market participants to limit their risk without constraining their ability to benefit if the market moves in a desired direction. In the case of a grower who fears that he has fixed a sales price too low, the purchase of a call at the same price would allow him to profit on the upside if the price increased – potentially eliminating the temptation to default on his cash contract.
Likewise, the mill concerned about fixing a price too high could gain protection against the possibility of a decline by buying a put. Just as important, options offer protection against a cash market default without requiring a futures position. Hedging in futures markets requires positions that are not taken to delivery to be liquidated and mark-to-market losses to be realized.
But the nature of options, which give buyers rights but not obligations, allows options to be exercised at the discretion of owners, following a specific development in the market. An in-the-money option position can be liquidated before (or at) expiration for an economic profit, or held to expiration in the underlying futures contract. A long option position that is out of the money at expiration can be (and almost always is) allowed to expire, without causing the holder of the option to assume a futures position.
For buyers, the risk of an option is limited to the premium, or price, paid for the purchase of a call or put. For options sellers, the risks can be substantially larger and potentially unlimited, with trading influenced by time remaining to contract expiration, volatility, short-term interest rates and a range of variables generally called “the Greeks.”
Because risks associated with owning puts and calls are limited, the clearing house does not assess margin on long options positions. Margins are charged on short options position, however, and will be charged if long option positions are exercised into futures.
Finally, because transactions on the exchange are backed by a clearing house that serves as the buyer to every seller and the seller to every buyer, participants on either side of the market – in futures or options – can be assured that their contracts will be honored.
This combination of factors – the sanctity of exchange-traded contracts, the ability to abandon long options positions and the margin treatment of long options – make them powerful hedging tools.