Dairy Futures and Options Tutorial

Understanding Dairy Based Options

As shown in the summary comments of the Understanding Hedging section of this workbook, the use of hedging as a risk management tool has the potential of locking in prices. The cost of this certainty is the inability to capture the benefits should prices move in a favorable direction. For example, with a dairy farm operator hedging production via Class III contracts, this operator precludes the ability to capture the benefits of increased Class III prices over that which was essentially locked in at the time of establishing the hedge. To overcome this limitation, producers and users of dairy products may want to evaluate the use of dairy-based options in the development of their marketing strategies. As will be shown in this section of the workbook, the use of options allows dairy industry participants the ability to protect against adverse price movements while at the same time maintaining the ability to capture the benefits of favorable price changes.

An option is a contract which gives the holder the right, but not the obligation to purchase or sell the underlying futures contract at a specific price within a specific time period. When you purchase a dairy-based option, the purchase is identified by the specific commodity, month, strike price and type of option (put or call), e.g., February $13.50 Class III PUT.

The following section of the workbook should help you become familiar with options and how they can be used to help manage your price risk.