Dairy Futures and Options Tutorial

Sell a Call

Objective

Use this option where there has been "sideways" price movements and option premiums are relatively high

You may want to use this strategy when there has been recent sideways price movements, option premiums are high and prices are expected to decline. In contrast to options purchases, but like hedgers, call sellers are required to establish a margin account. For purposes of this presentation we are ignoring the costs associated with maintaining this margin account including any opportunity cost of interest forgone.

In order to better understand this strategy, we provide an example of how selling a CALL can be used by a dairy farm operator to increase net Class III. Up to this point we have not talked about selling a CALL option. As some background, remember the buyer of a Class III CALL option is protecting his position against rising input costs. If prices fall, the CALL buyer will let the option expire and the seller of the CALL can apply the collected premium to help offset lower Class III's. If the Class III increases, the CALL buyer will exercise the option by buying a Class III futures at the strike price and the seller of that CALL will need to sell a Class III futures at the strike price. That is, when the CALL buyer exercises the CALL, the seller loses in the futures market because the seller takes a short position at the same strike price and then cash settles at the higher announced Class III.

Assume we have a dairy farm operator who in July notices that the November Class III futures has been trading at $12.95 which is a relatively high figure compared to the past 10 year's November Class III. This operator could hedge and lock in this Class III for a commission of $0.08/cwt round turn. (Note that in this example we are assuming zero basis risk. To determine the mailbox price simply add the Mailbox/Class III basis as discussed earlier). At the same time $13.00 November CALL options are trading at a $0.35 premium. This farm operator has discussed market conditions with the nearest university's dairy marketing specialist and the opinion is for the market to weaken with prices being relatively stable or possible slight declines. During the middle of July, the operator sells a November Class III call at the strike price of $13.00. In order to sell this option, a commission of $0.05 needs to be paid. The following Table shows the impacts of alternative announced Class III's on the net Class III received compared to a hedged position at $12.87 = $12.95 - $0.08.

Announced Class III CALL Call Buyer Exercise Option? Futures Market Loss Due to Call Buyer Exercise (+) Net Nov Class III Hedged Class III
Premium Collected (+) Commission (-)
$14.00 +$0.35 -0.05 Yes -$1.00 $13.30 $12.87
$13.50 +$0.35 -0.05 Yes -$0.50 $13.30 $12.87
$13.00 +$0.35 -0.05 Yes -$0.00 $13.30 $12.87
$12.00 +$0.35 -0.05 No -$0.00 $12.30 $12.87
$11.50 +$0.35 -0.05 No -$0.00 $11.80 $12.87
Note: We are assuming an $0.08/cwt roundturn hedging commission.

To summarize the results shown in the above table, if the announce Class III is higher than the CALL strike price, the buyer of that CALL will exercise the option and the dairy farm operator will need to go short on the futures market at the strike price and suffer a loss equal to the difference between the settle price and the strike price (e.g., sell a November Class III future at $13.00 and cash settle at the announced Class III, $14.00. No matter how high the announced Class III goes, selling a call effectively establishes a ceiling at the strike price plus CALL premium level - the option commission, in this case, $13.30.   Note that this ceiling price is higher than the hedged price. Of $12.87. If there is a sharp decline in Class III, then selling a CALL results in a net Class III that is less than the hedged price due to the decline in price being greater than the premium.   The producer would be better off hedging or buying PUTs. Only when the decrease in price is less than the CALL premium collected plus any commissions is the producer better off.   As such, selling a CALL as an output price management strategy should only be used during periods of relatively stable prices. Click here to view a diagram of the ceiling established relative to the hedged Class III.

Now that you are familiar with the Sell a CALL strategy, the following worksheet will allow you to examine how this strategy works.

B. Strategy

Below you can identify the contract month, commodity, strike price and premium collected for the CALL option you are selling.

  • Sell the call
    • Sell a call
    • At a strike price of
    • Pay an option commission of
  • Alternative Hedge Possibility:
    • As an alternative, you may want to hedge your product for a settle price of
    • You will need to pay a futures commission of
  • The buyer of this call pays you a premium of
  • The following price ceiling is established:
    Output Price Ceiling
    CALL Strike Price 0.00
    + Premium 0.00
    - Commission 0.00
    = Price Ceiling 0.00

C. Results

To examine the impacts of alternative settle prices, you can enter these settle prices below. The last column provides a comparison with the short hedge strategy when hedging at the futures price of 0.00

Settle Price 0.00 Class III Call Net Price under Sell-A-Call (=) Hedge Price Results
Call Loss (+) Pre,. (+) Comm. (-) Futures Price Hedge Commission (-) Net Hedged Price (=)
0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00