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Strategies for Tackling the Costs of Options

Dec 20, 2010

Dairy producers like the idea of having an insurance policy through puts and calls, but they don’t like the price tag. There are ways to combat this cost.

 
Spainhour PS jpegBy Jon Spainhour, Rice Dairy
 
In the past year, we have discussed several different futures and option strategies that dairy producers can employ when trying to establish a minimum price for their milk and a maximum price for the grain inputs. We have discussed fixed price contracts called futures and insurance type contracts called options. 
 
Within the discussion of options, we talked about different strategies that dairy producers can use, like buying puts, which establish a minimum price, or a floor, and leave the upside to market open for higher milk prices if they occur. We also talked about buying calls on our feed prices, which establish maximum prices for feed prices, while leaving the downside open if lower prices were to occur. 
 
One complaint producers have about strategies involving puts and calls is that they don’t want to spend the money associated with the strategy. They like the idea of having an insurance policy that protects them against the bad and allows them to benefit from the good, but they don’t like the price tag. Depending on the option, some strategies can be rather costly. 
 
One way we discussed for dairy producers to combat this cost of buying an insurance policy is to sell other options against their position. For instance, if a producer buys a $13.50/cwt. put, he may think about selling a $16.00/cwt. call against it. This strategy is often times called a risk reversal or a fence. By buying the $13.50/cwt. put, he has established a floor. 
 
However, that floor cost him a premium. By selling the $16.00/cwt. call, he established a ceiling for his milk at $16.00/cwt., but he collected a premium for doing so. By adding the call sale premium to this put buy premium, he has lowered the cost of protecting his downside. Of course, he has now limited his potential upside as well. The same can be done for his grain prices, only he is buying calls and selling puts.
 
Another strategy we have not discussed yet is what is commonly referred to as a put spread or a call spread. This strategy essentially involves establishing a floor at a higher level and then selling a floor at a lower level. For instance, a producer may want to protect himself against prices moving below $13.50/cwt., so he buys the $13.50 puts as discussed in the earlier example.
 
However, he may feel strongly that there is limited chance that the price of milk is going to go below $11.50/cwt. So he buys the $13.50/cwt puts and pays a premium while at the same time selling the $11.50/cwt. puts and collecting a premium. The net cost of protecting himself against $13.50/cwt. or lower milk has been reduced by selling the $11.50/cwt. puts. 
 
In this example, the producer has established a floor at $13.50/cwt. and is protected all the way down to $11.50/cwt. Below the $11.50/cwt. level, he is now exposed to the market again. This strategy is called a put spread. Producers can also use call spreads in the same way to protect themselves against rising grain prices. 
 
It should also be pointed out that, just like the fences we spoke about earlier, the secondary option doesn’t have to be sold at the same time you buy the initial protection. For example, a producer may buy the $13.50/cwt. puts while the market is moving lower. If the market does indeed move lower, the $11.50/cwt. puts are now worth more than they would have been earlier. He may wait until this point to sell them and get the better price. 
 
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 jcs@ricedairy.com.Visit www.ricedairy.com.
 
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