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Dairy trading experts offer strategies and practical perspectives to optimize market performance.

Buying Put Options to Protect your Milk Price, Your Business and Your Sanity

Oct 07, 2013

Dairies that have avoided buying put options because of their premium cost need to re-think that approach, says dairy broker Katie Krupa.

Katie Krupa photoBy Katie Krupa, Rice Dairy

Yes, you’ve heard me talk about buying put options before, but this article has a little different spin. I’ve talked to many dairy producers who have avoided buying put options because of the premium cost associated with the options. While I am not out to change anyone’s mind, I would like to challenge you to think about things a little differently.

Firstly, if your risk management plan is to utilize your equity position and/or relationship with your lender to manage through the price volatility, you may not need to do anything else for your risk management planning. Although this strategy is not an option for most dairymen, this is a suitable strategy for those who can manage the price volatility themselves (self-insure) with little financial stress to their business or personal stress to themselves and their families.

For the rest of you, I would start your risk management planning by looking at put options. Put options are appealing to many producers because you are able to protect the milk price from declining significantly without limiting the upside potential. Simply put, you pay a premium and get a level of price protection. Although put options are not insurance, the concept is similar, and most producers can better understand how put options work by thinking of them as insurance for the milk price.

The first complaint I often hear is, "I’m tired of paying all this money and getting nothing back." Although the concept of price protection seems good at first, after buying put options for some time and having the milk price settle above your strike price (so no payment is received from your purchased put option), many producers will begin to think that they should be "getting something back" for the money they used to purchase those put options.

While I can understand your desire to "get money," in this situation that’s the last thing you want to happen. If you purchase a $17.00 Class III put option for $0.40 and the Class III milk price settles at $14.00, your net Class III price is roughly $16.60 ($17.00 put, less $0.40 premium, less other possible brokerage or cooperative fees). But if the Class III price settles at $20.00, your net Class III price is roughly $19.60 ($20.00 price, less $0.40 premium, less other possible brokerage or cooperative fees). Which is better for your business: $16.60 or $19.60?

Obviously $19.60 is better than $16.60, but I know many of you are thinking that you would have been better off doing nothing because then you wouldn’t have the expense of put options, and your net Class III milk price would have been $20.00. Yes, you are correct. But, unfortunately, no one knows when the milk price will be $12.00 or $20.00, so you need to plan for either situation. Similar to insurance, you buy it, but you don’t want to use it!

Producers who consistently purchase put options will often say they’re buying more than price protection -- they are also buying peace of mind. How frequently do you worry about the future of the milk price -- couple times a month, a couple times a week, a couple times a day? If you worry about the milk price more frequently than you would like, you probably need a better risk management strategy. I can think of many producers who consistently buy put options because getting that level of price protection helps them better manage their dairy, and helps them sleep better too!

Lastly, many producers will say, "I want to buy put options but they are too expensive." Yes, these can seem expensive, but the reality of the level of price protection, peace of mind and ability to make longer-term decisions for your dairy may more than make up for the price. You have to look at risk management as a cost of running your business. It’s not fun or glamorous, but it may keep your business viable, regardless of high or low prices. Add risk management into your budget and make it part of your monthly expenses to protect the future of your business.

Katie Krupa is a broker 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 Katie at klk@ricedairy.com.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.

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