Popular Tactic: Offset Premiums While Establishing a Milk Price
Jul 02, 2010
By Jon Spainhour, Rice Dairy
Over the course of the past few months, we have discussed two types of risk management tools that dairy producers can use to help manage their output and input prices on their farm.
At first we discussed fixed priced contracts, called futures, which allow for dairy producers to establish a set selling price for their milk or a set buying price for their corn or soymeal. In either case, the ultimate price that the producer will sell his milk at or buy his inputs at will be determined by where he contracted them, regardless of where the spot price is at the contract expiration.
We also discussed contracts, called options, which act more like insurance than fixed price contracts. Producers can buy puts on specific price levels, called the strike price, which will establish insurance against their milk check going below that level. Puts are commonly referred to as floors. They can also buy calls, which is insurance against prices moving up, against their expected soymeal and corn input prices. Calls are commonly referred to as ceilings.
The beauty of options contracts is that they establish minimum prices of milk while still allowing the producer to benefit from upwards price movements. They also establish maximum prices for their input costs while still allowing them to benefit from downwards price movements. In both cases, the producer must pay a premium for their insurance.
So far, we have discussed the issue of options strictly from the perspective of buying insurance. However, in order for you to buy insurance, someone else has to sell it to you.
The person that sells a dairy producer a put/floor is essentially betting that the spot price will not go below the strike level. He is compensated for that risk by the premium that he collects. If the market goes below the strike level, he assumes all the risk below the strike level minus the premium that he collected. If the market settles higher than the strike level, he gets to keep the entire premium that he collected.
Dairy producers often times find the premiums that they have to pay for puts as being too expensive. One tactic they can employ is to sell calls/ceilings and use the premium that they collect to offset the cost of the puts/floors.
In this case, they are establishing a floor, which is the lowest price they will receive for their milk and paying for it by selling a ceiling, which is the highest price that they will receive for their milk.
This type of structure has several different names that you may have heard of at some point: windows, fences or risk reversals. Regardless of what name you use, it is a fairly straightforward structure that establishes a minimum and a maximum milk price.
For example, a dairy producer who wants to set a floor for his September milk production can buy $14.00/cwt. puts for $0.20/cwt. This means that the minimum price that he will receive for his production will be $14.00/cwt. He can offset the cost of the $0.20/cwt. premium by selling $16.00/cwt. calls and collecting $0.20/cwt. Under this structure, the maximum price that he will receive is $16.00/cwt. This means that for a net cost of zero, the producer has set a floor at $14.00/cwt. and a ceiling at $16.00/cwt.
The exact same type of strategy can be employed on the input side of the equation, only the producer can offset the cost of purchasing corn and soymeal calls by selling puts and collecting a premium.
I hope this was helpful, since I know that this can seem like a complicated subject matter. However, when broken down into simple components, I think it paints a more clear picture of a time-tested risk management structure that many dairy producers have been using for years to help manage their profitability.
Jon Spainhour is a broker/trader with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. You can reach Spainhour at email@example.com.Visit www.ricedairy.com.