Dairy Futures and Options Tutorial

Buy a Call

A. Objectives: Establish Input Cost Ceiling

Outlook
Market Could Increase
Performance Bond (Margin)
No
Price Ceiling
Yes
Price Floor
No

As noted earlier, the use of CALL options is one method by which users of dairy-based inputs can set maximum input costs. For example, suppose you are the milk procurement manager for a co-op that produces cheese. You can use Class III CALL options to establish a ceiling to your milk costs. Below is a worksheet that can be used to provide you with a better understanding of how to use a CALL option to manage your input cost risk. Unlike hedging, there is a possibility that by the time you reach the future period, your milk costs could be lower than the current Class III settle price. Via the use of an option instead of a hedging strategy, you can receive the benefits of this lower cost. In the following example it should be noted that we do not examine the dynamics of the plant's Class III basis. That is we assume zero basis risk. In the following example we include premiums as well as brokerage commissions. Given the different arrangements across commodity brokerage firms, you need to ask your broker whether the brokerage fee charged is for the initial purchase of the option only, or does it cover a round turn, that is, also the right to exercise the option. Many brokers charge an initial brokerage fee to purchase the option, and then another fee to exercise the option.

Assume it is July 15th, and given the plants costs of production and arrangement with the purchaser of its final product, you determine that a $12.50 Class III would generate an adequate return for cheese to be produced in November. This operator can purchase a November $12.50 Class III CALL (e.g., a $12.50 strike price) for a premium of $0.16. Suppose when the November Class III is actually announced on December 5th, it is $13.25. The following tables show how the producer can use this CALL to establish a milk cost ceiling less than the final announced Class III.

Establishment of Maximum Milk Cost
Class III Strike Price $12.50
+ CALL Premium (Purchase Commission) $0.16
+ CALL (Purchase) Commission $0.04
+ Futures (Exercise) Commission $0.05
= Maximum Milk Cost $12.75

With the announced Class III being greater than $12.55 the cheese plant can exercise the option and generate a net lower price for its milk recognizing that there are $0.20 in options-related costs that must be paid regardless of exercise decision. The following table shows this result when the announced Class III is $13.25.

Net Class III After Exercising $12.50 Class III CALL Option With $13.25 Announced Class III
Buy Class III (Strike Price) $12.50
- Cash Settle (Sell Futures Contract) $13.25
= Futures Market Gain $0.75
Announced Class III $13.25
- Futures Market Gain $0.75
+ Premium/Commissions $0.25
= Net Class III $12.75

Remember the Class III futures contracts are cash settled against the announced Class III for the month. By exercising the option, the producer will buy a Class III contract at the strike price ($12.50) and sell it back (cash settling) at the announced Class III ($13.25). The gain in the futures market can then be subtracted from the announced Class III to generate a lower net Class III of $12.75. Regardless of how far the Class III increases, the cheese plant will not pay a higher net Class III.

If the announced Class III is less than $12.55 ($12.50 strike price + $0.05 Futures commission) you should let the option expire worthless. This is illustrated in the following example:

Alternative Results of Exercising $12.50 Class III CALL When Announced Class III is Less than $12.55
Do Not Exercise Option Exercise Option
Announced Class III $12.25 Buy Class III (Strike Price) $12.50
+ Options Premium $0.16 - Cash Settle (Sell Futures Contract) $12.25
+ Options Comm. $0.04 = Futures Market Gain -$0.25
= Net Class III $12.45 Announced Class III $12.25
- Futures Market Gain -$0.35
+ Premium/Commissions $0.25
= Net Class III $12.85

Note that with a call option there is no limit on how low the net Class III can go.  A graphical representation of the price profile established using the above CALL option strategy can be seen by clicking here.

B. Strategy

  • Buy a call at a strike price of
  • Pay an option premium of
  • Pay a brokerage commission to purchase the options contract:
  • Pay a brokerage commision to purchase futures contract if option is exercised:

Note that we have included another cost to the option transaction, the broker commission. You need to ask your broker whether the brokerage fee charged is for the initial purchase of the option only, or does it cover a round turn, that is, also the right to exercise the option. Many brokers charge an initial brokerage fee to purchase the option, and then another fee to exercise the option.

Resulting Maximum Milk Cost
Strike Price 0.00
+ Premium 0.00
+ Options Contract Commission 0.00
+ Futures (Exercise) Commission 0.00
= Cost Ceiling 0.00

C. Impact of Alternative Settle Prices on Net Input Cost

Using the above information you can examine the impact of alternative final cash (settle) prices on the preferred action and net input cost. Enter three alternative settle prices and see how it changes whether you exercise of let your call options expire.

Class I Futures Settle Price Preferred Action Futures Gain (-) Cost of Action (+) Net Output Price (=)
None 0.00 0.00 0.00
None 0.00 0.00 0.00
None 0.00 0.00 0.00