Using Put Options to Protect Your Milk Price
Jul 04, 2011
Put options offer producers price protection without limiting your upside potential, and producers don’t have to worry about funding margin calls.
By Katie Krupa, Rice Dairy
When I talk to dairy producers about risk management, there are two frequent concerns that prevent them from entering a risk management strategy.
Firstly, many producers are concerned about contracting milk and missing out on potentially higher milk prices. Secondly, they are concerned about the cash requirement to maintain their margin account if the market should move against their contracted position.
By utilizing put options, dairy producers can protect their milk price, not limit their upside potential, and have no margin calls to maintain their margin account.
Put options trade on the Chicago Mercantile Exchange (CME) along with futures contracts. Options are a step beyond futures in that a futures contract sets a price, while an option gives the owner the choice of the market price or a pre-determined price. An option has a buyer and a seller – the buyer pays a premium to have the option of getting a set price in the future. The seller of contract collects the premium and provides the price if the buyer wants.
Let’s walk through an example to better understand. You’re a dairy farmer who wants to protect your Class III milk price for the month of September at $17.00. The current premium for a September $17.00 put option is $0.30 per cwt. As the dairy producer, you will buy the $17.00 put option for $0.30 per cwt. Each contract is 2,000 cwt. (200,000 lb.). You will buy one contract. Therefore, your total cost for the $17.00 put option is $600 ($0.30 x 2,000).
When working with a broker, one needs to pay the premium cost (in this example, $600) upfront when the trade is executed for the put. By paying the premium, the price is protected if the Class III price should fall below $17.00. No matter how low the September Class III price is for the month of September, your price will be $17.00.
So, for example, if September’s USDA announced Class III price is $14.00, you will have a margin account balance/credit of $3.00 per cwt. ($17.00 minus $14.00). Since you purchased one contract, the total account balance will be $6,000 ($3.00/cwt. x 2,000 cwt.).
Keep in mind you already paid the $600 premium upfront, so your net return will be $5,400. That $3.00 per cwt. in your brokerage account will compensate your milk check price, which will reflect the announced $14.00 Class III price.
So, we walked through what happens if the price should drop below our put option price, but what happens if the price should move higher?
If you buy a put option and the price goes up, you get the higher price. When buying a put option, you pay the premium, but you will not be limited from upside potential. So, for example, if the Class III price for September is announced at $19.00, your brokerage account balance will be zero, nothing owed and nothing due. But, again, you have already paid the premium of $600. Your milk check will reflect the $19.00 Class III price.
Maintaining your margin account by purchasing a put option is simple. Pay your premium upfront. That’s it. You will never have to add more money to the margin account if the price moves higher. In other words, there are no margin calls when buying put options. If the price should move lower, you will actually have a credit in your account.
Put options offer producers price protection without limiting your upside potential, and producers don’t have to worry about funding margin calls. Put options can be purchased in 25-cent increments ($17.00, $17.25, $17.50, etc.). The higher the put price, the higher the premium, and vice versa.
There are various strategies that can be employed by dairy producers to protect your milk price with put options. Risk management strategies are diverse and constantly evolving. I recommend talking with a professional to determine a strategy that works best for your farm business. Be sure to discuss all your needs and concerns before you enter or dismiss any risk management strategies.
Katie Krupa is the Director of Producer Services with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at email@example.com.Visit www.ricedairy.com.