By Jon Spainhour, Rice Dairy
Last month, we talked about using "futures” or fixed price contracts to hedge the price of our expected milk production. While fixed price contracts are a very useful hedging tool, there are other tools you can use that offer a little more flexibility. Those tools are called "options.”
There are two types of options. One is a "put.” The other is a "call.” Puts are essentially an insurance policy against prices moving lower. Calls are essentially insurance against prices moving higher. For the purpose of this discussion, we will focus on puts.
Puts are essentially like car insurance. To protect yourself against losing the value of your car if you get in a car wreck, you spend money to buy an insurance policy. Clearly, you don't want to get in a car wreck, but if you do, you are protected. Puts act in a very similar way, only instead of protecting yourself against a car accident, you buy an insurance policy against the price of milk going down.
In last month's example, our producer makes 1 million pounds of milk per month. Each Class III contract is for 200,000 lb. worth of milk. That means that in order to hedge himself completely, he will need to purchase five contracts worth of puts. Puts can be purchased on any price level in $0.25/cwt. increments. For example, that would be $13.00/cwt., $13.25/cwt. or $13.50/cwt.
In last month's example, we sold all five July contracts at $14.25/cwt. by selling futures. In that fixed price contract arrangement, the net price that we would receive for our milk would be $14.25/cwt., regardless of what the mailbox milk price was for July. With puts, we can buy insurance against the price of milk moving below $14.25/cwt., while at the same time getting to participate in the higher prices if the price of milk in July is higher than $14.25/cwt.