There are many risk management strategies available offering price protection for long hedgers of dairy products, such as processors, food companies and restaurants.
Other modules in this series describe strategies for long hedgers that involve either buying Dairy futures to lock in a purchase price, or buying Dairy call options to establish a maximum purchase price.
At times, however, long hedgers are interested in a strategy providing upside protection and the ability to take advantage of lower prices, but at less cost than simply buying a call option. One alternative is to buy a call option and simultaneously sell a put option.
This module will describe how dairy buyers can simultaneously purchase calls and sell puts. Not only will this allow the dairy buyer to establish a buying price range for the dairy products that he needs, but the premium he receives from selling the put option helps to finance, or reduce the cost, of buying the call. For the sake of simplicity, the examples will not take into account the dairy basis or futures transaction costs.
In an option strategy that creates a buying price range, purchasing a call option will set a ceiling price and selling a put option will set a floor price. The floor and ceiling prices are determined by the strike prices of the options: the hedger would choose a higher strike price for the call option he is buying, and a lower strike price for the put option he is selling.
Assume that it’s December and a food processor is planning to purchase 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 Milk futures price is $15 per hundredweight.
The processor is comfortable that buying milk at $15 will allow his operations to be profitable.
However, he decides to incorporate options into his hedging strategy to take advantage of any downward price movement and ensure the price he pays for milk will not rise above a specific level.
The processor has many different strike prices to choose from to establish his buying range. After considering the various strike prices, and taking into account his company’s objectives and risk exposure, he decides to buy an out-of-the-money Milk call option with a strike price of $16.50 for a premium of 20 cents, and simultaneously sell an out-of-the-money Milk put option with a strike price of $14 for a premium of 14 cents.
This means that he will implement the strategy at a net premium cost of 6 cents: the difference between the 20-cent premium he paid and the 6-cent premium he received. The net premium is added into the calculations to determine the ceiling and floor prices.
With this strategy the processor is able to establish a ceiling price of $16.56 per hundredweight, which equals the call strike price of $16.50 plus the 6-cent net premium he paid.
He also establishes a floor price of $14.06 per hundredweight: the put strike price of $14 plus the 6cent premium he paid.
The processor now has a buying price range for his milk. This means that no matter what happens in the futures market during the life of the option, his net buying price will be no higher than $16.56 per hundredweight and no lower than $14.06 per hundredweight.
If the futures price goes up to $17.50, the producer’s net buying price will be $16.56 per hundredweight: the futures price of $17.50 minus $1, which is the difference between the futures price and the call strike price, plus the 6-cent net premium he paid.
If the futures price drops to $13, his net buying price will be $14.06 per hundredweight: the futures price of $13 plus $1, which is the difference between the put strike price and the futures price, plus the 6-cent net premium he paid
The buying price range, $2.50, is the difference between the two strike prices. The processor will choose his price range based on his company’s risk tolerance level.
Also, it is important to keep in mind that as the seller of the put option side of the strategy, the food processor will be required to post a performance bond upfront at the time that he sells them.
Now that the food processor knows the minimum and maximum prices he will pay for milk, his company can plan and make decisions for their operations with a higher level of confidence.
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 higher prices to have peace of mind knowing that they have taken steps to manage the risk involved in buying these commodities.