Dairy Futures and Options Tutorial

Roll Up to A Futures

A. Objective

Establish a higher floor price when outlook turns bearish for continued output price increase (e.g. increased likelihood for lower prices).

The following example should help you understand how the Roll Up to a Futures strategy works. For this example we assume that you are trading in Class III futures and options. We assume your mailbox/Class III basis stays the same regardless of strategy adopted. Therefore we will ignore basis to simplify the presentation. Lets assume that in July, the October Class III futures contract is trading at $12.28. This level does not allow the farm operator to achieve his desired profit margin once his local basis is considered. The operator is reluctant to hedge at this level and forego the benefits of a higher Class III especially since the current trading level is much less than recent history. So on July 10th, the operator decides to purchase October Class III put options with a strike price of $12.25 for a combined premium/commission of $0.20, and futures-related commissions of $0.10, establishing a Class III floor of $11.95 = ($12.25 - $0.20 - $0.10). By August 8th the expectations of the operator have been fulfilled and there is a rally in Class III futures with the current October Class III contract trading at $12.75. With current market forecasts, the operator feels that the market will start to decrease in the near future. The operator therefore decides to sell (take a short position) October futures at $12.75 equal in amount to the previously purchased put options. This essentially establishes a new floor (and ceiling) for the Class III at $12.45 = [$12.75 - ($0.20+$0.10)] with higher actual announced Class III (note the additional dime is the cost of undertaking the hedge). Note that in this example we are assuming the futures related commission costs are the same when exercising the put versus undertaking the earlier hedge. The following table shows the outcomes if the final announced October Class III had been higher or lower than $12.75:

Announced Class III Futures Gain or Loss (+) Put-Related Costs and Returns Futures Comm. (-) Net Class III Net Class III Under Original PUT
Gain (+) Prem/Comm (-) Exercise Comm. (-)
$14.50 -$1.75 $0.00 $0.20 $0.00 $0.10 $12.45 $14.30
$13.75 -$1.00 $0.00 $0.20 $0.00 $0.10 $12.45 $13.55
$12.75 $0.00 $0.00 $0.20 $0.00 $0.10 $12.45 $12.55
$11.75 $1.00 $0.50 $0.20 $0.10 $0.10 $12.85 $11.95
$11.50 $1.25 $0.75 $0.20 $0.10 $0.10 $13.10 $11.95

Note because of both futures and options gains, when prices fall, the Rolling Up to a Futures strategy will always result in an improved net Class III price and there is no upper limit on the net Class III. Again note that for higher announced Class III's than the hedged price, this strategy places a ceiling on the net Class III, in this example, $12.45. In conclusion, Rolling Up to a Futures is a strategy that is best considered if there is a very good probability that after a rally in the Class III futures, a decline is quite certain. A person using this strategy cannot get hurt given a higher floor being established.  To see a graphical representation of this strategy click here

Given the above discussion, the following worksheet allows you to enter your own data to see how this strategy works.

Roll Up to a Future: Your Own Example

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

B. Strategy

Below you should identify the month, commodity, initial strike price, premium and commission costs for undertaking the initial purchase of the PUT option.

  • Buy a put at a strike price of
  • To purchase the option you will need to pay a premium of
  • To purchase the option you will need to pay a brokerage commission of
  • If you exercise your option you will need to pay a commission of:
This establishes an initial floor price of: 0.00 - 0.00 - 0.00 - 0.00 = 0.00
  • The settle price of the futures contract that sets off a trigger to set a new price floor via the sale of a futures contract is:
  • The round-turn cost of undertaking this hedge is:
  • The following higher floor price is established:
    Calculation of a Revised Floor Price
    Futures Trigger Price 0.00
    - Put Premium 0.00
    - Options Comm. 0.00
    - Futures (Exercise) Comm 0.00
    = Revised Minimum Price 0.00

(Note: You could increase this floor price if you sell your put option. This put should continue to have some time value since there is time left before contract expiration. For this analysis, we assume you are not selling this option).

C. Impact of Alternative Cash Settlement Prices

Given the above information, what is the impact of alternative cash settle prices on your net output price? In the left most column enter possible cash settle prices. The impact of having used a Roll Up to a Future strategy with a trigger of 0.00 is displayed in the next to last column while the use of only the original 0.00 put is displayed in the last column.

Settle Price Futures Gain (+) 0.00 Put Futures Comm. (-) Net Price (=) 0.00 Put Alone
Action Gain (+) Prem/Comm (-) Exercise Comm. (-)
0.00 None 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 None 0.00 0.00 0.00 0.00 0.00 0.00