Dairy Futures and Options Tutorial

Buy a Put

A. Objective: Protect Floor Price

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

One can use PUT options to establish a price floor for your output. Below we present an example of the mechanics of the use of a PUT option. In the following example we include the premium 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.

For purposes of this example, we will assume that you are a dairy farm operator using a Class III PUT option to establish a minimum Class III price. This example can be extended to the situation where you are a manufacturer of cheese, NFDM or some other dairy product. It should be noted that we do not examine the issue of the dynamics of the farm's Class III basis. That is, we assume zero basis risk.

Assume it is July 15th, and given your farm's costs of production, you determine that a $13.00 Class III would generate an adequate return. This operator can purchase a November $13.00 Class III (this is referred to as a $13.00 strice price) PUT for a premium of $0.16. Suppose when the November Class III is actually announced on December 5th, it is $12.00. The following tables show how the producer can use this PUT to receive a higher Class III than the announced Class III price.

Establishment of Minimum Class III
Class III Strike Price $13.00
- PUT Premium $0.16
- PUT (Purchase) Commission $0.04
- Futures (Exercise) Commission $0.05
= Minimum Ouput Price $12.75

With the announced Class III being less than $12.95 the dairy farm operator can exercise the option and receive a higher Class III. The following table shows this result when the announced Class III is $12.00.

Net Class III After Exercising $13.00 Class III PUT Option With $12.00 Announced Class III
Sell Class III (Strike Price) $13.00
- Cash Settle (Buy Futures Contract) $12.00
= Futures Market Gain $1.00
Announced Class III $12.00
+ Futures Market Gain $1.00
- Premium/Commissions $0.25
= Net Class III $12.75

Remember Class III futures contracts are cash settled against the announced Class III for the month. By exercising the option, the producer will sell a Class III contract at the strike price ($13.00) and buying it back (cash settling) at the announced Class III ($12.00). The gain in the futures market can then be applied to the announced Class III results in the $12.75 minimum price. Regardless of how far the Class III falls, the producer will not receive a lower Class III. If the announced Class III is greater than $12.95 ($13.00 - $0.05 Futures Commission), the producer should let the option expire worthless. This is illustrated in the following example:

Alternative Results of Exercising $13.00 Class III Put When Announced Class III is Greater than $12.95
Do not exercise option Exercise Option
Announced Class III $13.35 Sell Class II (Strike Price) $13.00
- Options Premium $0.16 - Cash Settle (Buy Futures Contract) $13.00
- Options Commission $0.04 = Futures Market Gain -$0.035
Net Class III $13.15 Announced Class III $13.35
+ Futures Market Gain -$0.35
Premium/Commissions $0.25
= Net Class III $12.75

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

B. Strategy

With the above example you can now experiment with the mechanics of the use of a put option. In the following example, the blank cells require you to enter data.

  • Buy a put at a strike price of
  • Pay a premium of
  • Pay a brokerage commission to purchase the options contract:
  • Pay a brokerage commission to purchase the futures contract if the option is exercised:
Resulting Minimum Output Price
Contract Strike Price 0.00
- Options Premium 0.00
- Options Contract Commission 0.00
- Futures (Exercise) Commission 0.00
= Minimum Output Price 0.00

C. Impact of Alternative Settle Prices on Net Output Price

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 or let your put option expire

Class III 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