Dairy Futures and Options Tutorial

Roll Down Futures to Put

A. Objectives

Use this strategy when you have originally hedged your output price, but now believe that the market has bottomed and that output prices will increase.

Similar to what we have done in previous strategies, we will illustrate the mechanics of this strategy using a dairy farm operator as the example. Under this strategy, with the producer having previously locked in output price via a short hedge there are revised Class III forecasts which predict higher Class III's. The producer would like to get out of the current short hedge.

In July, with a pessimistic Class III outlook and current prices generating an adequate return, the producer locked in his October Class III via a short hedge of October Class III futures (e.g., sold October Class III futures). By the end of August market reports are released which indicate due to extreme heat conditions in the West over the last couple of months, milk production in this region is lower than expected. Revised forecast are for higher prices during the last quarter of the year. The producer can offset his current futures position by buying an October Class III futures (instead of waiting until November 5th to cash settle). If he does this, he is now exposed to possible lower prices should his forecasts be wrong. To establish a price floor the producer would purchase an October Class III PUT as discussed earlier.

To see how this works, lets assume that on July 15th, the October Class III cash settles at 12.50. When adding his historical mailbox/Class III basis to this, the producer feels that he can generate an acceptable return. With forecasts for lower prices, he decides to hedge half of his expected October milk production and sells the necessary October Class III futures contracts to establish a short hedge. As noted above, by August 25th, the October Class III is now trading at $12.00 and has been at this level for some time. The producer feels that this represents the bottom of expected prices for the Class III. The producer therefore wants to lift his hedge and establish a price floor so that he could possibly take advantage of future price increases. He buys the same number of October Class III future contracts as was sold to initiate the hedge. Since he buys back the futures contracts at a lower price, he generates a profit of $0.50/cwt. He also buys an equivalent amount of October Class III PUTS at a strike price of $12.00 by paying a premium of 0.15 /cwt. The following October Class III floor is established:

Establishment of Price Floor for Oct. Class III
Class III PUT Strike Price $12.00
+ Futures Gain from Early Offset + $0.50
- Hedge Broker Commission - $0.06
- PUT Premium - $0.15
- PUT-Related Commission - $0.03
- PUT Exercise Commission - $0.03
= October Class III Floor = $12.23

The following table provides a summary of the impacts of alternative announced Class III's given the above data:

Strategy Summary: Initial Hedge at $12.50, Lift Hedge at $12.00, Buy Put Option at $12.00

Announced Oct. Class III Futures Gain From Early Offset (+) Hedge Comm.(-) Put Option Net Class III Net Class III Under Hedge Only
Action Gain (+) Prem (-) Comm. (-) Futures Comm. (-)
$13.50 $0.50 $0.06 Let Expire $0.00 $0.15 $0.03 $0.00 $13.76 $12.44
$12.50 $0.50 $0.06 Let Expire $0.00 $0.15 $0.03 $0.00 $12.76 $12.44
$12.00 $0.50 $0.06 Let Expire $0.00 $0.15 $0.03 $0.00 $12.26 $12.44
$11.50 $0.50 $0.06 Exercise $0.50 $0.15 $0.03 $0.03 $12.23 $12.44
$11.00 $0.50 $0.06 Exercise $1.00 $0.15 $0.03 $0.03 $12.23 $12.44

Note that for decreases in the announced Class III below the strike price of $12.00, the net Class III does not fall below the floor of $12.23. Also for slight increases in the Class III above the strike price, the hedged results would have resulted in higher net Class III's given the hedge was initiated when the Class III was at $12.50. The following figure provides a graphical representation of this example.

Given the above example in the next section you can input your own values and examine the impacts of alternative market conditions on your net output price if you had adopted a roll-down-to-a-future strategy.

B. Strategy

There are three steps to undertaking this strategy. First you need to establish a short hedge. Then you need to identify what you expect the bottom of the price expectations for the particular future contract. Finally, you need to lift your hedge and purchase a PUT option.

Establishment of Short Hedge
  • Selling a futures contract
  • The contract's settle price at time of hedge:
  • Undertaking this hedge requires the payment of a broker commission of:
Setting of Trigger Price
  • You need to identify the settle price for the futures contract you consider to be the bottom of anticipated price decreases.
  • The trigger you set is:
Lifting Hedge Position
  • Assume that the trigger price for the futures contract occurs
  • At this time you need to purchase a contract to lift your previous hedge
  • You will purchase a PUT
    • The strike price will equal: 0.00
    • You will pay a premium of:
    • You will pay a commission to purchase the put of:
  • If you need to exercise your PUT you will pay a commission of
With the above information the following floor is established:
PUT Strike Price 0.00
+ Futures Gain from Early Offset + 0.00
- Hedge-Related Broker Commission - 0.00
- PUT Premium - 0.00
- PUT-Related Commission - 0.00
- PUT Exercise Commission - 0.00
= Floor Price = 0.00

Given the above information and the example shown in Section A, below we provide you with the opportunity for examining the impact of having adopted this strategy under a number of alternative final settle prices. The next to last column shows you the net output price received under the Roll-Down-to-a-Future strategy. The last column provides a comparison if you had adopted a short hedge strategy at the initial settle price of 0.00.

C. Comparison of Alternative Cash Settle Prices on Roll-Down-Futures-to-Put Strategy

Settle Price Futures Gain (+) Hedge Comm. (-) 0.00 PUT Net Price (=) Hedged Net Price
Action Gain (+) Prem. (-) Comm. (-) Exercise Comm. (-)
0.00 0.00 None 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 None 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 None 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 None 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 None 0.00 0.00 0.00 0.00 0.00 0.00

Note that if the price goes up above 0.00 then you will do better than if you had stayed with the original hedge.