Case in Point: Historical Example of Dairy Price Hedging with Put Options
Aug 01, 2011
Here’s a real example of a trade strategy utilizing put options that returned an average $0.20 per cwt. to the dairy producer over 40 consecutive months.
By Katie Krupa, Rice Dairy
Dairy farmers are frequently skeptical about using futures or options to protect their milk price. The concern is that the person on the other side of the trade knows more about the market, so the dairyman’s trade will always result in a loss of money to the dairyman.
In order to debunk this myth, below is a real example of a trade strategy utilizing put options and returned an average $0.20 per cwt. to the dairy producer over 40 consecutive months.
For this example, the dairy producer is going to purchase a put option to protect his or her milk price. Put options require buyers (dairymen) to pay a premium upfront. In return, they are protecting their milk price from declining below their chosen level of protection. If the milk price should increase, the producer will receive the higher milk price, less the premium that was already paid.
For this example, I wanted to set up an easy-to-follow strategy, so I simply purchased a put option for a cost around 20-35 cents per cwt.
I purchased put options for four consecutive upcoming months, waited four months and then I purchased the next four consecutive months. The first purchase was made on 1/15/2008. I purchased a $15.00 put option for the months of March-June 2008, for an average cost of $0.22 per cwt. Then, on 5/15/2008, I purchased a $17.50 put option for July-October 2008 for $0.21 per cwt.
I continued this strategy through 2011, and the prices are outlined in the table.
This strategy is simply based on time (contracting every four months) and takes no trade recommendations into account. I am providing this example to show that even trading done on a schedule, rather than market insight, can help producers protect their milk price. The outcome of the above outlined strategy is price protection when milk prices are low, but limited losses (just the paid premium) when the milk price moves higher.
2008 – In 2008, the milk price began to decline during the summer months. The puts options that were purchased for the spring and summer months expired worthless. (The premium was paid, but the milk price was higher than the level of price protection). Later in the year, the milk price declined below the purchased $17.50 put, so there was a return from the purchased put option. In total, the average difference from USDA’s announced Class III price was -$0.03 per cwt. (There was a $0.03 per cwt. loss). That is, $744 on an annual basis for one milk contract of 200,000 lb. per month – roughly the milk produced from 100 cows.
2009 – This was the worst year the dairy industry had experienced in recent history, but the put options that were purchased helped protect the milk price from completely bottoming out. In January 2009, the USDA Class III price was $10.78. A $15.00 put was purchased on 9/15/2008 for 35 cents, so the net gain for January was $3.87 per cwt. In February, the USDA Class III price was $9.31, but the $15.00 put that was purchased for 40 cents provided a net return of $5.29 per cwt. In total for the year, the put option returned an average of $0.77 per cwt., which is $18,380 for the year for one contract (200,000 lb. per month).
2010 – This was a much better year than 2009, but still prices were relatively low during the first half of year, and the purchased puts did return some value. In total, the average difference from USDA’s announced Class III price was $0.07 per cwt., or $1,700 for the year.
2011 YTD – Prices have been improving in 2011, which means the put premium was paid, but the puts are expiring worthless, which is a good thing because milk prices are moving higher. Year to date, the average difference is -$0.19 per cwt., or -$2,331 for the six months that have settled this year.
2008-2011 Summary – The average price difference from the Class III price is $0.20 per cwt., which is nearly $18,000 for one 200,000 lb. contract (100 cows).
This historical example using put options illustrates how dairymen can protect their milk price but still benefit when prices change direction and move significantly higher. There are numerous other hedge strategies that can be employed. This is just one example. As always, I recommend producers talk with industry professionals, become educated and make decisions that are best for their unique farm business.
Katie Krupa is the Director of Producer Services with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at firstname.lastname@example.org.Visit www.ricedairy.com.