There are many risk management strategies offering price protection for long hedgers in the dairy industry, those involved in buying dairy and dairy products. Market participants such as dairy manufacturers, processors, food companies and restaurants are concerned about the impact that an increase in the price they pay could have on their business, and are constantly seeking ways to mitigate this risk and protect their bottom line.
Buying dairy futures contracts allows long hedgers to lock in a purchase price, because a loss in the cash market is made up by a gain in the futures market, and vice versa. This strategy will completely satisfy the needs of many long hedgers, who calculate the purchase price that will allow their business to be profitable.
However, some long hedgers would like the ability to establish a maximum purchase price, while still being able to take advantage of a potential decline in dairy prices. That is where options come in, offering price protection plus flexibility.
This module will describe how dairy buyers can purchase call options to establish a maximum or ceiling purchase price, while still maintaining the opportunity to buy at a lower price. For the sake of simplicity, the examples will not consider the dairy basis or futures transaction costs.
Assume that it is December and a manufacturer is planning to buy milk for his operations in early spring. He is concerned that milk prices may increase by the time he is ready to make his purchase in March. The current March Class 3 futures price is $15.50 per hundredweight.
The manufacturer determined that paying $16.00 per hundredweight for milk will allow his operations to break even, so he is attracted by the possibility of being able to purchase milk at a lower price.
One alternative is to lock in the purchase price of $15.50 with a long futures hedge, in other words, by buying March Class 3 Milk futures at $15.50. However, the manufacturer decides to use call options to establish a ceiling purchase price, and retain the opportunity to potentially buy his milk at a lower price. With the call option, he has the right to buy futures at the strike price of the option.
In December, a March at-the-money Class 3 Milk call option with a strike price of $15.50 costs 50 cents. With this call option, he will establish a ceiling price of $16.00, which equals the call option strike price of $15.50, plus the 50-cent premium he paid for the option. If milk prices rise, this is the maximum price he will pay.
Suppose in March, the Class 3 Milk futures price rises to $17.00 per hundredweight. This is $1.50 higher than the manufacturer was anticipating back in December.
But since the call option gives the manufacturer the right to buy Class 3 Milk futures at $15.50, even though the current futures price is $17.00, the call option has a value of at least $1.50: the $17.00 futures price minus the strike price.
Deducting the 50-cent premium means a net gain of $1.00 on his call option hedge, giving him an effective net purchase price of $16.00 per hundredweight: the $17.00 futures price minus the gain on the call option. Again, no matter how high milk prices rise by the time he is ready to buy his milk in March, the highest price he will pay is $16.00.
Suppose the March Class 3 Milk futures price drops below the $15.50 strike price. In this situation, the manufacturer will still be able to participate in the downward price movement.
For example, say March Class 3 Milk futures drop to $14.00 per hundredweight. Since the $14.00 futures price is lower than the $15.50 strike price of the call option, the manufacturer allows the option to expire and buys his milk in the cash market.
The most he will lose is the 50-cent premium he paid upfront. His net purchase price will be $14.50, which is the futures price of $14.00, plus the 50-cent premium.
With milk prices rising, the net purchase price of $16.00 was higher compared to the $15.50 he would have locked in with the long futures hedge. The difference, essentially, being the option premium.
The manufacturer was quite willing to pay the premium, however, because it allowed him to secure protection from rising prices and—unlike the long futures hedge—still can pay a lower price for his milk in a declining market: $14.50 per hundredweight vs $15.50 with a long futures hedge.
He will pay more for his milk in this scenario than the $14.00 had he not hedged at all—the difference, again, being the option premium. But, knowing that the price could just as easily have risen, he was willing to pay this cost to ensure a maximum selling price for his milk.
Keep in mind that the manufacturer also has the possibility of selling his call option for any time value that it may still hold. Whatever he receives from selling the option would lower his net purchase price even further.
To summarize the benefits of buying call options for the long hedger:
No one can predict the future, but hedgers can take steps to manage it. Using dairy futures and options allows those who need protection against rising prices to have peace of mind of knowing that they took steps to manage the risk involved in buying dairy and dairy products for their business.