Dairy Futures and Options Tutorial

Cash Contract / Buy a Call

Many dairy farm operators have the option for forward contracting their milk. To familiarize you with the strategy of combining a forward cash contract with a call option we again use the example of a dairy farm operator. Assume it is July and the October Class III future contract is trading at $12.50. This dairy farm operator estimates that this is about the average for October Milk received over the last decade. He therefore enters into a cash forward contract with his dairy coop buyer to purchase 200,000 lbs of milk for $12.40 ($12.50 - $0.10 administrative costs). By mid-August, market forecasts have changed and now indicate reduced supplies and therefore higher prices than normal in October. Without changing his marketing strategy, the farm operator will not be able to capture the benefits of these higher prices. One way to modify his strategy is to buy a CALL option (which gives the owner the right to purchase a contract at a specific strike price). Currently, an October Class III CALL at a strike price of $13.00 can be purchased for $0.16 and must pay a commission of $0.04. If the farm operator purchases this CALL, it will be exercised if the announced Class III ends up higher than $13.00. If the CALL option is exercised a futures commission of $0.05 is assumed to be paid. The profits from this exercise (buy at $13.00 and sell at a higher announced Class III price) will then be added to the contract price. The following table provides a comparison of the results of this strategy with the original forward priced Class III.

Announced Oct. Class III Strike Price Cash Contract Class III CALL Option Futures Comm. (-) Net Class III Price
Gain (+) Premium (-) Comm. (-)
$14.00$13.00$12.40$1.00$0.16$0.04$0.05$13.15
$13.75$13.00$12.40$0.75$0.16$0.04$0.05$12.90
$13.25$13.00$12.40$0.25$0.16$0.04$0.05$12.40
$12.50$13.00$12.40$0.00$0.16$0.04$0.00$12.20
$11.50$13.00$12.40$0.00$0.16$0.04$0.00$12.20
$11.00$13.00$12.40$0.00$0.16$0.04$0.00$12.20

With the adoption of this strategy, the farm operator only gains if the announced October Class III increases above the CALL option strike price sufficient to cover premium and commission costs. If it does not, he has paid the CALL premium and commissions which need to be deducted from the contract price regardless of whether the CALL is exercised. This can be seen by comparing the last column of this table with the contract price shown in the second column. Although lower, the use of the CALL established a floor price at $12.20, $0.20 less than the contract price. Thus there is a trade-off between the possibility of receiving a net Class III above the contract price with a reduced floor. In summary, this strategy may want to be used when there is a good probability that prices will increase more than any premiums and commissions associated with the use of the CALL option. For a graphical representation of this result click here.

Given this introduction, the following worksheet provides you the capability of entering your own information to examine the risk/return tradeoffs with this strategy.

A. Objectives

Use this when markets you have forward priced your product and there is a good probability for significant price increases.

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

B. Strategy

  • Forward Contract your at
  • Later buy a January Class III CALL at a strike price of
  • Pay CALL-related premium and commission of
  • If I exercise this call, then pay an additional commision of
The following price floor is established:
Contract Price 0.00
- Call Premium and Commission 0.00
= Minimum Price 0.00

C. Comparison of Alternative Announced Class III's

What is the impact of alternative final announced Cash prices levels on your net output price using the Cash Contract then Buy a Call Strategy? Below, you can enter alternative cash prices to examine these impacts. Note that when the commission is at a zero value, the CALL is not exercised. What is the price floor established. How is this determined? How does the net price compare with the strategy of only forward pricing your production?
Final Cash Price Forward Contract 0.00 CALL Net Price (=)
Action Gain (+) Prem. & Comm. (-) Exercise Comm. (-)
0.00 None 0.00 0.00 0.00 0.00
0.00 None 0.00 0.00 0.00 0.00
0.00 None 0.00 0.00 0.00 0.00