Dairy Futures and Options Tutorial

Example of the Use of a Put Option to Establish a Floor Price For Your Output

As a first example of the use of options, below is a worksheet that allows you to understand the workings of a put option. Since you are purchasing a put option, we assume that you want to establish a floor for your output price. Unlike hedging, there is a possibility that by the time you reach the future period, your output price will be higher than the current settle price for the commodity. Via the use of an option instead of a hedging strategy, you can receive this higher price for your output. In the following table, enter your desired strike price, premium, commission costs, and basis information. The resulting minimum output price is displayed.

The Put Option you would like to purchase:

Establishment of Minimum Output Price
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 Floor Price for Output = 0.00

Just like an insurance premium, the option's premium is lost regardless of whether the option is exercised. You also must pay the option's contract commission even if you do not exercise the option.

Similar to the example you just completed, the following diagram provides another example of how a put option establishes a price floor. For this example we assume that the purchaser is a dairy operator who wants to protect his June production. Note that if the announced Class III stays below $12.75, the producer can lock in a net price of $12.60/cwt. Above $12.75, the producer obtains a net price of market price - premium - options related commission .

Use of Put Option to Establish a Price Floor

Estimated Floor Price
Also known as minimum selling price - as market prices decrease below strike price, put options gain value
Unlimited Upside Potential
If market prices increase, net selling price = higher cash price minus premium paid
Pay Premium
Premium paid in full up front -- no margin obligation