Dairy Price Risk Management Session 6: Options

1. Dairy Price Risk ManagementSession 6: Options Cooperative Extension – Ag and Natural Resources Farm and Risk Management Team Last Update: May 1, 2009

2. What Are Options Contacts? • A PUT option is the right – but not the obligation – to SELL a futures contract at the strike price • A CALL option is the right – but not the obligation – to BUY a futures contract at the strike price • The price of the option is called the PREMIUM • Premiums depend on: • Strike price relative to futures price • Time to expiration • Futures price volatility • Options are seldom exercised – there is no advantage to exercising the class III options because they are cash settled against the announced USDA class III price

3. Options Terminology #1 (for put buyers) • Premium: The “price” of a put option. • Strike Price (Sometimes called Exercise Price): The price of the underlying futures contract you would receive if you exercised your option, There will be trading in options with several different strike prices for the same contract month. • Exercise: Assume a short futures position at the strike price. The put seller takes the opposite position. You’ll need to pay a separate brokerage fee and post margin applicable to the futures contract

4. Options Terminology #2 (for Put Buyers) • Offset: Sell a put in the same month at the same strike price as the put your bought. Offsetting removes you from the market • In the money/out of the money: Refers to the difference between the current futures price and the strike price of your put. If there would be an immediate gain from exercising (the futures price is less than the strike price), your put is in the money. • Intrinsic Value: The amount by which your put is in the money, i.e., the monetary gain from exercising your put option. Your put is out of the money if it has no intrinsic value • Time value: Current option premium less intrinsic value

5. Put buyer Pays premium Has the right to exercise into a SHORT futures position Pays no performance bond (margin) Put seller Collects premium Has the obligation to accept a LONG futures position if assigned Insures put buyer by depositing and maintaining margin Put Options – Buyers and Sellers

6. Intrinsic and Time Value of Options:(Nov ‘09 Class III @ $15.21 on 04/24/09)

7. How Do Put Options Provide a Price Floor? • Suppose You need a $14.00 milk price to keep your banker happy • The October Class III is trading at $13.83. If that price holds: $13.83 + $1.17 Basis = $15.00 = Happy banker • But suppose the October Class III price is announced at $12.50: $12.50 + $1.17 Basis = $13.67 = Unhappy banker • You’re fairly confident that the Class III price will be at or above $13.83 when it’s announced, but you don’t want to take the chance of it falling below $12.83 (= $14.00 – $1.17 Basis)

8. How Do Put Options Provide a Price Floor (2)? • Solution: Buy an October Class III $13.75 Put at $.83. Minimum Price: $13.75 Put strike price + 1.17 Basis - .83 Premium - .05 Commission = 14.04 Net minimum price Announced Option Option Net Oct. Class III Basis Gain Premium Comm. Price $12.00 +1.17 +1.75 -.83 -.05 14.04 $13.50 +1.17 + .25 -.83 -.05 14.04 $15.00 +1.17 -0- -.83 -.05 15.29

9. How Do Put Options Provide a Price Floor (3)? • BUT WAIT – Wouldn’t you be better off selling the Oct Class III futures at $13.83????? Fixed Price: $13.83 October Class III + 1.17 Basis - .05 Commission = 14.95 Net fixed price Announced Futures Net Oct. Class III Basis Gain/loss Comm. Price $12.00 +1.17 +1.83 -.05 14.95 $13.50 +1.17 + .33 -.05 14.95 $15.00 +1.17 - 1.17 -.05 14.95 • Options allow you to benefit from rising prices, but at a cost (the premium). SO: Whether you hedge or buy a put depends on your expectations about future prices. • QUESTION: What is “breakeven” Class III price (at which futures hedge and put purchase yield same net price)?????

10. Pros and Cons of Buying Put Options • Advantages: • Provide price floor in volatile markets • Give flexibility in the amount of price protection desired – can select your “deductible” • In contrast to futures, can benefit from upside price movements • No margin requirement • Disadvantages • Premiums are very high in unstable markets • Less price protection than futures in a falling market

11. CME Class III Milk Options Contract Specifications The CME also trades a “midi” option, which is ½ the volume of the standard option..

12. Put Option Examples (1)

13. Put Option Examples (2)

14. Imperfect Hedges • Production uncertainties - Can’t perfectly predict production • Lumpy contracts - Can’t purchase options (or sell futures) exactly equal to volume of production Expect to sell 225,000 pounds of milk in Sep. Buy 1 CME Sep 13.00 put @ $.40. Sep futures is $13.75. Basis is + $1.50 and Commission is $.05. Minimum price is $13.00 (strike) + 1.50 (basis) - .40 (premium) - .05 (commission) = $14.05. Announced Sep Class III @ settlement is $12.00. September milk sales are 250,000 pounds. Basis is $1.50 Q: What is your net price?

15. Imperfect Hedges (2) Sell milk to plant @ $13.50 (12.00 Class III + 1.50 Basis) +/- Options gain/loss + .60 (1.00 gain - .40 premium • Commission - .05 Net price 14.05 Floor price ON HEDGED MILK BUT: Hedged only 200,000 pounds, so 50,000 pounds unhedged Gross milk revenue $33,750 (2,500 CWT * $13.50) - Total Premium 800 (2,000 CWT * $ .40) + Option Gain 2,000 (2,000 CWT * $ 1.00) - Total Commission 100 (2,000 CWT * $ .05) = Net Revenue $34,850 Divided by 2,500 CWT = $13.94

16. Hedge, Buy Puts, or Do Nothing?It all Depends….. Basis = + $1.20; Commission (futures or options) = $0.05)

17. Hedge, Buy Puts, or Do Nothing?It All Depends….. • If you know prices are going to fall relative to current levels, then hedging (sell futures contract) is the optimal choice – even if the futures price doesn’t meet your price goal • If you know prices are going to rise, then do nothing • If the odds are 50-50, then buying puts will provide down-side price protection but leave the opportunity for up-side gains. But remember that when you buy puts, there was always a better choice after the fact. • Problem: Ya Never Know! So take action to meet your financial and personal goals, not to beat the market