A primer on put options
Published in Dairy Star July 8, 2006
As milk prices are dropping the interest in milk marketing is increasing. Judging by the number of calls I have had over the past few weeks there seems to be a lot of questions about put options as a milk pricing tool.
Put options (puts) are a milk marketing tool that can be used to set a minimum Class III milk price. One put option represents 200,000 pounds of Class III milk. They are bought and sold daily on the Chicago Mercantile Exchange (CME). Put options are available for every month for which Class III futures contracts are traded.
There are three parts to a put.
- The strike price is the predetermined price that you can sell a futures contract, if you chose to exercise your put. Exercising your put means you are selling a futures contract for the strike price.
- The premium or the price you pay to purchase a put. Puts are purchased through a licensed broker. The minimum Class III price you can receive is the strike price minus the premium minus the broker fee.
- The third part of a put is the expiration date. A put is not exercised, it expires on the last day of trading of the futures contract to which it is tied.
An example may make things a bit clearer. On June 23rd a Class III futures contract traded at $12.09 per hundred weight (cwt). I could have purchase December 2006 put option with a strike price $12/cwt for $0.68/cwt. If I do not exercise the put (sell a December 2006 Class III milk futures contract) by the time the put expires, the put will expire worthless. The premium was $0.68. The broker fee was $60 or 0.03/cwt. The minimum price I will receive for 200,000 pounds of my December 2006 milk is $12.00 minus $0.68 minus $0.03 equals $11.29/cwt. If the Class III price falls below my strike price of $12.00 I can exercise my put and sell a futures contract for $12.00. If the announced price for December 2006 milk is above $12.00 the put expires without being exercised. A put can be exercised at any time between the time you purchase the put and when the put expired.
Strike prices are available in 25 cent increments ranging from about $2.00 above and below the Class III futures. For example, the strike prices available for December 2006 ranged from $10.50 to $14.50, with the December Class III milk futures trading at $12.09.
One rule of put options is 'the higher the strike price, the greater the premium.' Another rule for puts is 'the more time there is between when you buy the put and when the put expires, the greater the premium will be.' This is known as the time value of the put.
Let's use December 2005 as an example. The December 2005 Class III futures contract and put options began trading in July 2004. The last day of trading for December 2005 Class III futures contracts was January 6, 2006. This was the day the December Class III milk price was announced. I had opportunities to purchase December 2006 put options from July 2004 through January 6, 2006. Table 1 shows the average premium for a $12 strike for December 2005 Class III milk.
|Table 1. Average premium for a $12.00
December 2005 put option
Put options with $12.00 strike prices for December 2005 Class III milk were not trading from November 2005 through January 2006. At that time the Class III futures contracts were trading over $13.00. December 2005 Class III milk was announced at $13.37.
If I purchased a $12.00 December 2005 put in July of 2004, I would have paid a premium of $1.11. The total cost of the put would have been $2,220. There are 17 months between the time I purchase the put and when December 2005 Class III milk price is announced. There is a lot of time for the December Class III futures price to fall below the strike price.
If I purchased a $12.00 December 2005 put option in October 2005, I would have paid a premium of $0.02. The total cost would have been $40. There are 2 months between the time I purchased my put and when the December 2005 Class III price is announced, which is less time for Class III futures contract to trade below the strike price.
There are two key things to remember about the premiums of put options:
- The higher the strike price the higher the premium. The higher the strike price, the more likely Class III futures contract associated with that put will trade below the strike price and the more likely the put will be exercised.
- The time value of put options. The more time there is between when I buy a put and when the Class III price is announced, the higher the premium.