Know Your Market
Protect Your Input Prices
Jun 07, 2010
By Jon Spainhour, Rice Dairy
So far in this column, we have discussed the difference between fixed price contracts, called futures, and flexible priced contracts called options. In last month’s column, we discussed options contracts that are called puts.
Puts are essentially insurance contracts that allow for producers to establish a floor on the price of their expected milk production. By purchasing puts, a producer can know today what the minimum price he/she is going to receive for their milk at some point in the future, while still being able to participate in higher prices if the price of milk moves higher.
This type of contract is different from a fixed priced contract, which allows producers to establish a guaranteed price for their milk but does not allow them to participate in any of the upside if the price of milk were to move higher.
Another type of option that is used in risk management is the call option. Calls are very similar to puts from the standpoint that they are essentially an insurance contract as well. However, they are insurance against the price of a commodity moving higher. The buyer of the call is establishing a ceiling on prices of a certain commodity, while still allowing themselves to participate in lower prices if the price moves lower.
In the milk world, puts are most commonly used by producers who sell their milk, trying to establish a floor against lower prices. Calls are typically employed by end users like restaurants and food companies, who buy milk, trying to establish a ceiling on their milk price.
Producers, however, don’t just have output price risk to worry about. They also have input price risk in the form of feed and energy prices that they need to worry about too. The most common method that dairy producers use to manage that input price risk is by buying futures or options on their feed prices. While not all of their feed prices can be hedged through futures and options, inputs like corn, soymeal, cotton and canola oil can all be hedged through these instruments.
For example, a producer today can establish a ceiling on his corn inputs for December at $4.00/bu. by purchasing $4.00/bu. calls at $0.17/bu. This means that the maximum price that he is going to pay for his corn during the month of December is going to be $4.17/bu. ($4.00 + $0.17 premium).
If come December the spot price of corn is $5.00/bu., the producer will pay his supplier $5.00/bu. However, his options account will have $0.83/bu. worth of profit in it. When you apply those profits to his spot price, you get a net price of $4.17/bu.
If come December, the spot price of corn is $3.00/bu., he will pay his supplier $3.00/bu. His call options that he spent $0.17/bu. on, however, will expire worthless. This means that his net pay price for corn in Dec will be $3.17/bu.
In either case, he was able to know today that the maximum price that he would have to pay for his corn in Dec would be $4.17/bu. This same method of hedging corn can be applied to the other exchange traded commodities like soymeal, canola oil and cotton as well.
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 firstname.lastname@example.org.Visit www.ricedairy.com.