Is Now the Time for a Three-Way Collar?

Published on: 10:47AM Sep 17, 2012

This option hedging strategy is preferred when Class III milk futures are in the upper portion of their historical range.

Carl BablerBy Carl Babler, Atten Babler Commodities

Dairymen who have continued along the milk risk management learning curve have added the three-way collar option strategy to their marketing toolbox. This producer strategy involves the purchase of a put option along with the simultaneous selling of both an “out of the money” call option and put option.

Dairy Producer Three-way Collar example (with Oct ’12 – Mar ’13 Class III trading $19.25):
• Sell the $21.00 call
• Buy $18.50 put
• Sell $16.50 put

So, what’s the story with a three-way option collar? In essence, three-way collars provide producers with a lower premium cost due to the sale of the further out-of-the-money options. However, as usual, there is no free lunch. Thus, this strategy has both an upside price limit (at the price level of the sold call) and a downside hedge protection limit (at the level of the sold put).

In exchange for reducing the cost of the strategy by selling the out-of-the-money put and call, the producer is also taking on additional risks. These risks include:

1) The risk that prices could go lower than the out-of-the-money-sold put option; and
2) The risk that prices could go above the sold call.

Declining price activity could result in a producer’s downside milk price hedge coverage being capped out or limited, while increasing prices could result in margin calls and a producer’s upside participation being limited.

The three-way collar strategy embraces the minimum price philosophy appropriate for milk hedging. Over time, the milk price distribution has shown the value of not fixing or capping out price opportunity with a given strategy. It is preferred to employ a strategy that will allow the producer to benefit from higher milk price opportunities if they unfold during the term of the hedge. Producers are finding it more applicable to use straight purchased puts or fence strategies (i.e., buy a put and sell an out-of-the-money call) for their milk price risk management actions in lieu of sold futures and fixed price cash contracts. For these producers, the three-way collar is a natural additional strategy alternative to be considered since it leaves room for upside price participation up to the level of the sold call.

The three-way collar has some pronounced differences when compared to using a long put or fence strategy. These differences can be observed by reviewing recent option premium quote examples for these three alternate marketing tactics.

For example, let us assume a dairy producer wishes to establish a Class III Milk price floor for expected production for the period of time from Oct ‘12 thru March ‘13. The average Class III Milk futures price for this period is $19.25. The producer wishes to compare his option strategy choices:

• Buy a straight $18.00 put for $.40/cwt. premium

     - Result: Hedged $1.25 below the market (less the premium and transaction cost), no price cap or downside hedge protection limit, no margin call obligation.

• Buy $18.50 put / Sell $21.00 call “Fence” strategy for $.23 cwt. premium
     - Result: Hedged $.75 below the market (less the premium and transaction cost), capped out at prices above $21.00, no downside hedge protection limit, margin call obligation on the sold $21.00 call.

• Buy a Three-Way Collar - Sell $16.50 put/Buy $18.50 put/Sell $21.00 call for a net premium of $.11/cwt. 
     - Result: Hedged $.75 below the market (less the premium and transaction cost), capped out at prices above $21.00, downside hedge protection limit at the $16.50 put. The long $18.50 puts will cover the margin call potential of the short $16.50 puts. Thus, the only margin call potential is on the sold $21.00 call.

Those using the three-way collar have found it useful when there is a longer period of time involved in the position. Selling a time premium of two options is advantageous in mitigating a portion of the time-related premium cost of the desired purchased put.

The three-way collar strategy is preferred when Class III milk futures are in the upper portion of their historical range, as is the current $19.25 futures average for Oct ‘12 thru March ‘13 relative to the historical high Class III announcement of $21.76.

Time also may allow the holder of the three-way collar to buy back one or both of the sold options during the term of the hedge as futures prices move. The offset of the sold call options thus removes the cap and margin call obligations while the offset of the sold put would remove the limitations on the downside hedge participation.

The ability to manage the risk and limitations of the position should be considered a positive feature of the strategy. The margin obligation is the same as the fence strategy and requires the producer to have a dedicated line of credit to fund the position to term regardless of the amount of margin called for. Liquidating the three-way collar for margin-call reasons may incur substantial premium loss due to sold option premium volatility.

When looking at the above strategy choices, individual producers should make their selection based on profitability, price level, premium cost, the price limitations and the margin obligations. Those producers that have an understanding of various hedge strategies will be best positioned to make a strategy selection that fits their hedge objectives risk tolerance and financing capacity.

Risk in purchasing options is the option premium paid plus commissions and fees. Selling futures and/or options leaves you vulnerable to unlimited risk. Transaction cost used throughout this report includes both commissions and fees. Atten Babler Commodities LLC uses sources that it believes to be reliable, but it cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. Unless otherwise stated, the information contained herein is meant for educational purposes only and is not a solicitation to buy futures or options. The author of this piece currently hedges for his own account and has financial interest in the following derivative products mentioned within: Class III milk.

Carl Babler is a principal with Atten Babler Commodities of Galena, Ill. Contact him at [email protected] or 877-259-6087.