By Jon Spainhour, Rice Dairy
Last month, we talked about using "futures” or fixed price contracts to hedge the price of our expected milk production. While fixed price contracts are a very useful hedging tool, there are other tools you can use that offer a little more flexibility. Those tools are called "options.”
There are two types of options. One is a "put.” The other is a "call.” Puts are essentially an insurance policy against prices moving lower. Calls are essentially insurance against prices moving higher. For the purpose of this discussion, we will focus on puts.
Puts are essentially like car insurance. To protect yourself against losing the value of your car if you get in a car wreck, you spend money to buy an insurance policy. Clearly, you don't want to get in a car wreck, but if you do, you are protected. Puts act in a very similar way, only instead of protecting yourself against a car accident, you buy an insurance policy against the price of milk going down.
In last month's example, our producer makes 1 million pounds of milk per month. Each Class III contract is for 200,000 lb. worth of milk. That means that in order to hedge himself completely, he will need to purchase five contracts worth of puts. Puts can be purchased on any price level in $0.25/cwt. increments. For example, that would be $13.00/cwt., $13.25/cwt. or $13.50/cwt.
In last month's example, we sold all five July contracts at $14.25/cwt. by selling futures. In that fixed price contract arrangement, the net price that we would receive for our milk would be $14.25/cwt., regardless of what the mailbox milk price was for July. With puts, we can buy insurance against the price of milk moving below $14.25/cwt., while at the same time getting to participate in the higher prices if the price of milk in July is higher than $14.25/cwt.
Let's go through two examples. In both examples, we will buy five July $14.25 puts. Just like car insurance, you have to pay for the right to protect your milk price. That price is referred to as the premium. We will assume that the premium that we spent to buy the $14.25 puts was $0.30/cwt.
In the first example, we will pretend that the mailbox price of milk for July ends up at $12.50/cwt. We bought insurance against the price moving below $14.25/cwt., and we paid $0.30/cwt. for that protection. So, our net mailbox price is going to be $13.95/cwt. While we will only receive $12.50/cwt. from our cooperative, we have $1.45/cwt. of profit ($14.25/cwt. options minus $12.50/cwt. milk check minus $0.30/cwt. premium) in our options account that we can apply toward our $12.50/cwt. milk check. This brings our net price to $13.95/cwt. ($12.50/cwt. milk check plus $1.45/cwt. options profit).
In the second example, we will pretend that the price of milk for July ends up being $17.00/cwt. In this case, our net milk check will be $16.70/cwt. ($17.00/cwt. milk check minus $0.30/cwt. premium). In my opinion, this is the obvious ideal situation. This producer was able to know as the beginning of May that the lowest price that he would receive for his milk would be $13.95/cwt. ($14.25 puts minus $0.30/cwt. premium), while at the same time getting to participate in the higher prices if the price of milk went higher.
I see puts as the ideal way for producers to hedge their milk, and we typically advise them to try and buy puts at levels that at least protect their break-even costs. That way, while they may not be making money if the price of milk plummets, they will at least not be losing money, which will reduce the risk of them going out of business.
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.