Dairy Futures and Options Tutorial

Roll Up to a Put

A. Objective:

For purposes of this tutorial we will use the Class III as an example commodity. Lets assume you are a dairy farm operator and it is early July and the October Class III futures is trading at $12.28. You have established a price floor on 200,000 lbs of October milk production by purchasing a Class III PUT option from the CME at $12.25 for a premium of $0.15 resulting in a Class III floor of $11.98 = ($12.25 -$0.15 - $0.07 - $0.05). The $0.07 and $0.05 deductions are the options and futures commissions, respectively, which must be paid to a commodity trader to sell a futures contract at the options strike price. A month passes and the October Class III is now trading at $12.85. At this time an October Class III PUT option at a strike price of $12.75 can be purchased for $0.20/cwt. The local university extension agent has advised you that a number of milk production areas are experiencing weather-related production drops while the upper Midwest has had ideal forage producing conditions that could lead to possibly increased production. With this information, you expect higher Class III's in the fall but should the Midwest’s production exceed expectations, there is a possibility of lower prices.

Given the settle prices observed for October Class III contracts in August, you decide to purchase an additional October Class III PUT at a strike price of $12.75. Because it is early August the previously purchased October Class III PUT at a $12.25 strike price can be sold for $0.10. With the recent purchase of the October Class III and selling of the previously purchased PUT, the farm operator has established a price floor for this 200,000 lbs of milk of $12.31 = $12.75 - [costs of exercising $12.75 PUT] - [costs of original $12.25 PUT] +[revenue from sale of $12.25 PUT] = $12.75 -[$0.20 + $0.07 + $0.05] - [$0.15 + $0.07] + $0.10. The following Table provides a summary of the impacts of alternative announced Class III prices on the net Class III price compared to the original PUT strategy.

Note: When a PUT is not exercised the futures commission is not paid.

In summary, if the announced October Class III is higher than the $12.75 trigger than the net Class III is higher under the original PUT strategy than under the Roll Up to a Put strategy. Alternatively, if the Class III does in fact turn lower than the $12.75 PUT, the Roll Up To a Put results in a higher net Class III. Thus under this strategy, higher net Class III's (relative to the PUT strategy) can be expected if the announced Class III decreases after the purchase of the second PUT while there is also a sacrificing of some increases should the Class III in fact increase above the trigger.

For a graphical representation of the price profile established by the adoption 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 Put: Your Own Example

Outlook:

Market Could Decrease

Performance Bond (Margin):

No

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.