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Weighing the Costs and Benefits of Using Options

Oct 18, 2013

Options are perhaps the most desirable tools in many market profiles yet the least understood. CIH’s Chip Whalen explains when it makes sense to consider buying the put option over selling futures.

chip whalen thumbBy Chip Whalen, CIH

In managing forward profit margins, dairy producers have many contracting alternatives at their disposal in both their local cash market as well as through the use of exchange-traded derivatives.

When considering the latter class of choices, options are perhaps the most desirable under many market profiles yet the least understood. We often find that dairy producers as well as other livestock integrators and clients we work with struggle to understand option strategies and how they benefit their operations. While the space for this article is hardly adequate to answer all questions and bring clarity to a complex topic, I hopefully can help shed some light on a subject that is hard for most to comprehend.

Most of you are already probably aware that an option is a contract that conveys the right to buy or sell a commodity futures contract at a set price for a pre-determined period of time in consideration of a cost which is referred to as the option’s premium.

The option’s premium is a function of many components, including the price level at which the right to buy or sell exists, how much time remains to exercise this right to buy or sell, the price at which the underlying futures contract is trading at, and how volatile the price of this underlying futures contract has been historically.

One of the common objections to using options we often hear from producers is the cost of the premium. While it is true that options carry a cost, there is also a benefit that comes with them. When you purchase an option, you are not obligated to the price and therefore retain the opportunity for that price to improve in your favor. As an example, let’s consider a milk option for illustration purposes. Suppose I have just completed updating my financials such that I can determine my cost of production moving forward. For simplicity sake, let’s also assume I grow my own forages such that I know my feed costs and I can estimate my non-feed expenses with reasonable accuracy.

In this case, the main variable to my forward profit margin is going to be the price of milk. Although my mailbox check will include components and depend on utilization levels for the various classes of milk (let’s assume I am on the Federal Order), futures prices are going to be a large part of the overall variance in price between now and the time I eventually receive my milk check. Looking at Q2 of 2014, let’s assume I am projecting a forward profit margin of $1.30/cwt. This is based on the input cost of both feed and non-feed expenses I have already calculated, and the forward price of milk being projected by CME futures in that time period. Looking at the July Class III contract which would be the middle of that marketing period, the current price is just over $17.00/cwt.

As one alternative, I could simply "lock in" this price by selling a futures contract, and essentially establish a projected forward profit margin for Q2 at $1.30/cwt. (should my cost projections prove accurate along with non-milk revenue assumptions along with basis considerations for components, PPD, etc).

Another alternative would be to purchase the right to sell futures at $17.00/cwt. by buying a put option at that strike price, which is currently offered at $0.80/cwt. in the July contract, representing the midpoint of that Q2 marketing period. With this strategy, I am essentially protecting a minimum milk price of $16.20/cwt., and by extension, a minimum profit margin of $0.50/cwt. ($1.30 gross profit margin minus $0.80 put option premium).

Given that the feed costs are already known in our example -- since we grow our own forages and we are comfortable with the other cost and revenue projections -- let us now focus strictly on the milk price. The main contractual difference between "locking in" a price of $17.00 and protecting the $17.00 price level as a floor is that in the former case we are obligated to the price whereas in the latter case we are not, we simply have the right to sell at that level. The question therefore becomes under what scenario are we better off choosing to sell futures over buying a put option? The answer is we are better off buying the put if the price moves higher; specifically, by more than the amount that we pay for the premium of this option. While somewhat counterintuitive, we want the put to depreciate and lose money.

As many of you may also already know, when you purchase an option, you can lose the entire premium paid for the right which was purchased. In the above scenario, if we spend 80 cents to purchase a milk put that gives us the right to sell futures at $17.00 cwt., the worst case scenario is that we lose all the premium which is paid for in full at the time the option is purchased. The cost therefore is fairly straightforward – the most the option is ever going to be is 80 cents. What’s the benefit? We retain the opportunity for milk prices to appreciate in a rising market, therefore preserving the potential to sell our milk at a higher level and receive a larger milk check.

Where the benefit outweighs the cost is when the milk has appreciated by more than what we paid for this benefit. While somewhat simplistic, one question you might ask yourself when evaluating the merits of the two strategy alternatives is whether or not you believe July Class III Milk futures will eventually be higher than $17.80/cwt. between now and expiration of the contract. If the answer to this question is yes, then it may well make sense to consider buying the put option over selling futures.

You might be reading this and think that if I have a bullish bias towards price, wouldn’t I be better off doing nothing and simply staying open to the market on my milk price risk? While this may be true, the reality is that none of us can know for sure what is going to happen between now and next July. At least with buying the option, I know my worst-case scenario, which, in this example, is a positive margin of $0.50/cwt. That may help you and your family sleep better at night and bring greater comfort to your dairy operation. I suppose while we are on the topic of weighing costs and benefits, another reasonable question to ask is what is that benefit worth?

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or cwhalen@cihedging.com. 

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