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Overprotecting price with "put options"

Margot Rudstrom

Published in Dairy Star December 23, 2006

In my December 9th article, I talked about the importance of having milk production to back up the hedge. One message of concern I tried to present in that article was-if I hedge more milk than I produce and if the milk price rises, I will incur a loss.

In this article, I would like to center our attention on "put options." Put options can be used to set a floor or minimum price for Class III milk. For each put option there are a series of strike prices. For each strike price there is a different premium. The strike price is the amount at which I can sell a Class III futures contract.

When I purchase a put option I have the right to sell a Class III futures contract at the put strike price, or in marketing terms "I can exercise my option." Because put options are tied to Class III futures contracts, purchasing one put option sets a minimum Class III price for 200,000 pounds of milk.

Let's look at an example of overprotecting the milk price with a put. Going back to January 2006, suppose at that time I expected to produce 100,000 pounds of milk in November 2006. On January 17, 2006, I purchased a $12.50 November 2006 put for $0.39/cwt. Notice that the put option has a strike price, a premium, and a month associated with it. The strike price is $12.50/cwt. If I decide to exercise my option, I can sell a futures contract for $12.50/cwt. The total premium I paid was $780, which is the premium $0.39/cwt multiplied by 2,000 hundredweights (200,000 lbs). As a result, the price floor I set for my Class III price is the strike price ($12.50) minus the premium ($0.39), or $12.11/cwt.

Let's say I keep my put option until the November 2006 Class III futures contract expired on December 1, 2006. The November 2006 announced Class III price was $12.84. Where did I end up? I received $12.84/cwt for Class III. Since the November 2006 Class III announced price was greater than the $12.50 strike price, the put expired worthless.

Suppose the announced Class III price was $12.10. Since this is below my strike price of $12.50, I will exercise my put option. That means I will sell a November Class III futures contract for the strike price of $12.50 and have the futures contract settle (buy it back) for $12.10. That means I will have a gain of $0.40/cwt on a 200,000 futures contract. My total gain is $20 after I deduct the cost of the put.

Date Put expires worthless Put is exercised
January 17th, 2006 Buy a 200,000 put option with a $12.50 strike for $0.39/cwt Buy a 200,000 put option with a $12.50 strike for $0.39/cwt
Announced Class III $12.84 If it was $12.10
December 1, 2006 Put option expires worthless Put option is exercised at $12.50
Gain/loss -$780 $800-$780 = $20

What is the difference between hedging and puts when overprotecting milk to pricing more milk than I will produce? When I use a put, I know how much I paid for the premium. The premium I paid is the cost to me, regardless of how much the milk price increases over my strike price. If I hedge more milk than I produce and the milk price rises, there is also a cost to me. The more the price is above my futures contract, the greater the loss to me.

Puts, contract, hedging … Learning about these milk pricing tools takes time. The more time you can spend learning about these tools and what they can and cannot do for you, the more comfortable you will become with them.

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