Dairy Futures and Options Tutorial

Use of Alternative Combinations of Hedging/Options Strategies

Previous sections of this tutorial have discussed the use of short and long hedges for price risk management. Below we provide an overview of more advanced marketing strategies. These strategies used a combination of dairy futures and/or options that could be used to manage your price risk. The specific combination depends on your marketing objectives and recent cash price trends.

Following the description of each strategy we provide an example illustrating the use of that particular strategy.   For each strategy, we provide a graphical analysis of the price profile obtained from each stratgey.  The spreadsheet file used to generate these graphs can be obtained by clicking here.   Following this pre-set example there is a worksheet provided where you can input your own data to help you better understand this strategy. (Note that in these examples we have not included your basis as it would only complicate the example. To determine the impacts on the final output price or input cost you need to add the basis. For a discussion of the role of basis in determining your final price and basis risk click here.)

  1. Buying a PUT:

    • Use when you want to establish a minimum price for your output while leaving the opportunity for you to benefit from future price increases
    • May consider this as a strategy anytime recognizing it is a conservative strategy
    • Consider it when commodities futures are trading at prices that are not attractive to your price/cost objective, but don’t want the situation to deteriorate any further
    • A better outcome than hedging when output prices actually increase
    • Buying a Put Example
  2. Buying a CALL:

    • Use when you want to establish a maximum cost for your dairy inputs while allowing for you to possiblly benefit from possible input cost decreases
    • May consider this as a strategy anytime recognizing it is a conservative strategy
    • Consider it when commodities futures are trading at prices that are not attractive to your price/cost objective, but don’t want the situation to deteriorate any further
    • A better outcome than hedging when input prices actually decrease
    • Buying a Call Example
  3. Roll Up to a Futures:

    • A good strategy to consider following a period of ever increasing output prices but now there is a good probability that prices will decline
    • Producer establishes a output price floor by purchasing a PUT option
    • Futures market outlook turned bearish (feeling that prices will decline)
    • Producer will undertake a short hedge (sell futures) to establish a higher price floor
    • If cash price does indeed drop, net price will come out better than the original PUT option
      • Possible gain from both the PUT and hedge
    • If cash price increases, the established new higher floor price is also a price ceiling
      • Loss from the hedge offsets gains from rising prices
    • Roll Up to a Futures Example

    4. Roll Up to a PUT:

    • Strategy should be considered after a rally in product's futures price
    • Price outlook is for continued price increases
    • You still are cautious
    • Producer first purchases a PUT option to establish an initial floor price
    • Strategy allows producer to buy another PUT option at a higher strike price to establish a higher floor price
    • Original PUT option can be sold to re-capture part of premium paid
    • If prices do increase, the net price will be lower than the original PUT strategy
      • The first premium will not be able to be recovered
    • If prices decrease, net price will be higher because of the higher floor
    • Roll Up to a Put Example

    5. Cash Contract and Now Buy a Call:

    • Consider after price outlook for your product turns from bearish to bullish (expect prices to increase)
    • Farm operator establishes a "base price" through forward milk price contract system
      • When the contract was entered into, the price outlook was bearish (expected prices to decline)
      • Currently, outlook is for much stronger prices
    • Producer buys a CALL option to establish a floor price lower than the original contract price by CALL option premium
    • If the milk prices increase, a gain will be realized by exercising the CALL option
      • Net mailbox price (if a Class III contract) will be higher than original contract price
    • If prices decrease, the net mailbox price will be lower by the amount of the premium
    • Cash Contract and Now Buy a Call Example

    6. Sell a Call:

    • Consider when there has been a sideways movement in output price (output price neither increasing or decreasing) and options premiums are relatively high (can collect a good premium when sell an option)
    • Establishes a ceiling for your output price at a higher level than if had hedged when prices increased
    • Requires caution as there is no floor to how low your output price could go if prices actually decrease
    • Sell a Call Example

    7. The Short Fence (Buy a Put/Sell a Call):

    • Consider this when market opinion is slightly bullish (prices may increase) and premiums for options are relatively high
    • Usually buys an out-of-the-money PUT option first and sells an out-of-the-money CALL
    • Establishes both a price ceiling and floor (hence the name short fence)
    • If output price increases, net price comes out better than if had hedged
    • If prices decrease, net price is lower than if had hedged
    • The Short Fence Example

    8. Roll Down Futures to Put:

    • Strategy may be considered when producer has originally undertaken a short hedge
      • Output price have since gone down
      • Producer is of the opinion that prices have bottomed and are about to rise
    • The producer gets out of the hedge by offsetting (buying a futures)
    • Buys a PUT option to establish a floor price in case the above forecast is wrong and output price declines further
    • If output prices increase, the new price will be higher than the original hedge
    • If output price decreases, net output price will be lower
    • Roll Down Futures to Put Example