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Dairy Price Risk Management Session 6: Options. Cooperative Extension – Ag and Natural Resources. Farm and Risk Management Team. Last Update: May 1, 2009. What Are Options Contacts?. A PUT option is the right – but not the obligation – to SELL a futures contract at the strike price

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dairy price risk management session 6 options
Dairy Price Risk ManagementSession 6: Options

Cooperative Extension – Ag and Natural Resources

Farm and Risk Management Team

Last Update: May 1, 2009

what are options contacts
What Are Options Contacts?
  • A PUT option is the right – but not the obligation – to SELL a futures contract at the strike price
  • A CALL option is the right – but not the obligation – to BUY a futures contract at the strike price
  • The price of the option is called the PREMIUM
  • Premiums depend on:
    • Strike price relative to futures price
    • Time to expiration
    • Futures price volatility
  • Options are seldom exercised – there is no advantage to exercising the class III options because they are cash settled against the announced USDA class III price
options terminology 1 for put buyers
Options Terminology #1 (for put buyers)
  • Premium: The “price” of a put option.
  • Strike Price (Sometimes called Exercise Price): The price of the underlying futures contract you would receive if you exercised your option, There will be trading in options with several different strike prices for the same contract month.
  • Exercise: Assume a short futures position at the strike price. The put seller takes the opposite position. You’ll need to pay a separate brokerage fee and post margin applicable to the futures contract
options terminology 2 for put buyers
Options Terminology #2 (for Put Buyers)
  • Offset: Sell a put in the same month at the same strike price as the put your bought. Offsetting removes you from the market
  • In the money/out of the money: Refers to the difference between the current futures price and the strike price of your put. If there would be an immediate gain from exercising (the futures price is less than the strike price), your put is in the money.
  • Intrinsic Value: The amount by which your put is in the money, i.e., the monetary gain from exercising your put option. Your put is out of the money if it has no intrinsic value
  • Time value: Current option premium less intrinsic value
put options buyers and sellers
Put buyer

Pays premium

Has the right to exercise into a SHORT futures position

Pays no performance bond (margin)

Put seller

Collects premium

Has the obligation to accept a LONG futures position if assigned

Insures put buyer by depositing and maintaining margin

Put Options – Buyers and Sellers
how do put options provide a price floor
How Do Put Options Provide a Price Floor?
  • Suppose You need a $14.00 milk price to keep your banker happy
  • The October Class III is trading at $13.83. If that price holds:

$13.83 + $1.17 Basis = $15.00 = Happy banker

  • But suppose the October Class III price is announced at $12.50:

$12.50 + $1.17 Basis = $13.67 = Unhappy banker

  • You’re fairly confident that the Class III price will be at or above $13.83 when it’s announced, but you don’t want to take the chance of it falling below $12.83 (= $14.00 – $1.17 Basis)
how do put options provide a price floor 2
How Do Put Options Provide a Price Floor (2)?
  • Solution: Buy an October Class III $13.75 Put at $.83.

Minimum Price: $13.75 Put strike price

+ 1.17 Basis

- .83 Premium

- .05 Commission

= 14.04 Net minimum price

Announced Option Option Net

Oct. Class III Basis Gain Premium Comm. Price

$12.00 +1.17 +1.75 -.83 -.05 14.04

$13.50 +1.17 + .25 -.83 -.05 14.04

$15.00 +1.17 -0- -.83 -.05 15.29

how do put options provide a price floor 3
How Do Put Options Provide a Price Floor (3)?
  • BUT WAIT – Wouldn’t you be better off selling the Oct Class III futures at $13.83?????

Fixed Price: $13.83 October Class III

+ 1.17 Basis

- .05 Commission

= 14.95 Net fixed price

Announced Futures Net

Oct. Class III Basis Gain/loss Comm. Price

$12.00 +1.17 +1.83 -.05 14.95

$13.50 +1.17 + .33 -.05 14.95

$15.00 +1.17 - 1.17 -.05 14.95

  • Options allow you to benefit from rising prices, but at a cost (the premium). SO: Whether you hedge or buy a put depends on your expectations about future prices.
  • QUESTION: What is “breakeven” Class III price (at which futures hedge and put purchase yield same net price)?????
pros and cons of buying put options
Pros and Cons of Buying Put Options
  • Advantages:
    • Provide price floor in volatile markets
    • Give flexibility in the amount of price protection desired – can select your “deductible”
    • In contrast to futures, can benefit from upside price movements
    • No margin requirement
  • Disadvantages
    • Premiums are very high in unstable markets
    • Less price protection than futures in a falling market
cme class iii milk options contract specifications
CME Class III Milk Options Contract Specifications

The CME also trades a “midi” option, which is ½ the volume of the standard option..

imperfect hedges
Imperfect Hedges
  • Production uncertainties - Can’t perfectly predict production
  • Lumpy contracts - Can’t purchase options (or sell futures) exactly equal to volume of production

Expect to sell 225,000 pounds of milk in Sep. Buy 1 CME Sep 13.00 put @ $.40. Sep futures is $13.75. Basis is + $1.50 and Commission is $.05. Minimum price is $13.00 (strike) + 1.50 (basis) - .40 (premium) - .05 (commission) = $14.05.

Announced Sep Class III @ settlement is $12.00. September milk sales are 250,000 pounds. Basis is $1.50

Q: What is your net price?

imperfect hedges 2
Imperfect Hedges (2)

Sell milk to plant @ $13.50 (12.00 Class III + 1.50 Basis)

+/- Options gain/loss + .60 (1.00 gain - .40 premium

  • Commission - .05

Net price 14.05 Floor price ON HEDGED MILK

BUT: Hedged only 200,000 pounds, so 50,000 pounds unhedged

Gross milk revenue $33,750 (2,500 CWT * $13.50)

- Total Premium 800 (2,000 CWT * $ .40)

+ Option Gain 2,000 (2,000 CWT * $ 1.00)

- Total Commission 100 (2,000 CWT * $ .05)

= Net Revenue $34,850

Divided by 2,500 CWT = $13.94

hedge buy puts or do nothing it all depends
Hedge, Buy Puts, or Do Nothing?It all Depends…..

Basis = + $1.20; Commission (futures or options) = $0.05)

hedge buy puts or do nothing it all depends1
Hedge, Buy Puts, or Do Nothing?It All Depends…..
  • If you know prices are going to fall relative to current levels, then hedging (sell futures contract) is the optimal choice – even if the futures price doesn’t meet your price goal
  • If you know prices are going to rise, then do nothing
  • If the odds are 50-50, then buying puts will provide down-side price protection but leave the opportunity for up-side gains. But remember that when you buy puts, there was always a better choice after the fact.
  • Problem: Ya Never Know! So take action to meet your financial and personal goals, not to beat the market
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