Dairy Futures and Options Tutorial

Example of the Use of a Call Option to Establish a Maximum Dairy Input Cost

As noted earlier the use of CALL options are one method by which users of dairy-based inputs can set maximum costs of these inputs. For example, a cheese manufacturer can used Class III CALL options to establish a maximum milk cost. Below is a worksheet that allows you to understand the workings of a CALL option. Unlike hedging, there is a possibility that by the time you reach the future period, your milk costs could be lower than the current Class III settle price. Via the use of an option instead of a hedging strategy, you can receive the benefits of this lower cost. In the following table, enter the strike price, premium, commissions and expected basis for the desired option. Your maximum input cost will be displayed.

The Call Option you would like to purchase:

Establishment of Maximum Input Cost
Strike Price [Price at which buyer has right to sell particular futures contract]  
+ Premium [Amount to paid for right to sell futures at this strike price] -
+ Options Contract Commission [Brokerage fee for purchasing options contract] -
+ Futures Contract Commission [Brokerage fee for purchasing futures contract] -
+ Basis [Estimated difference between cash and futures over a particular marketing period] +
= Estimated Maximum Input Cost = 0.00

Just like an insurance premium, the premium is lost regardless of whether you exercise the option. In addition, the options-related commission is lost as well.

Similar to the example you just completed, the following diagram provides another example of how a CALL option establishes a price floor. For this example we assume that the purchaser is a co-op cheese plant that wants to set a maximum June milk cost. Note that if the announced Class III stays above $12.75, the producer can lock in a net cost of $12.90/cwt. Below $12.75, the cheese plant pays a net price for their cheese milk of the announced Class III + the premium+ the options contract commission.

Use of Call Option to Establish a Cost Ceiling

Estimated Cost Ceiling
As cost of dairy-based inputs increase above strike price, call options gain value
Unlimited Downside Potential
If market price decreases, net input cost price = lower cash price plus premium paid
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