There are many risk management strategies available offering price protection for short hedgers involved in producing or selling dairy products, such as dairy exporters, manufacturers and food processors.
Other modules in this series describe risk management strategies for short hedgers that involve selling futures to lock in a selling price, or buying put options to establish a minimum selling price
At times, short hedgers are interested in a strategy that provides downside protection and the ability to take advantage of higher prices, but at less cost than simply buying a put option. One alternative is to buy a put option and simultaneously sell a call option.
This module will describe how dairy sellers can simultaneously buy puts and sell calls. Not only will this allow the seller to establish a selling price range for his dairy, but the premium he receives from selling the call option helps to finance, or reduce the cost, of buying the put.
In an option strategy that establishes a selling price range, buying a put option will set the floor price and selling a call option will set the ceiling price. The ceiling and floor prices are determined by the strike prices of the option, so a hedger would choose a lower strike price for the put option he is buying, and a higher strike price for the call option that he is selling.
Assume it is December, and a cheese exporter is planning to sell a portion of his inventory of cheddar in early spring. He is concerned cheese prices may decline by the time he is ready to sell in April. The current April Cheese futures price is $1.65 per pound.
The cheese exporter is comfortable that selling his cheese at the expected price of $1.65 will allow his operations to be profitable.
However, he decides to incorporate options into his hedging strategy to take advantage of any upward price movement and ensure the price he gets for his cheese will not drop beyond a specific level.
The cheese exporter has many different strike prices to choose from to establish his selling range. After considering the various strike prices and considering his objectives and risk exposure, he decides to buy an out-of-the-money Cheese put option with a strike price of $1.55 for a premium of 5 cents, and simultaneously sell an out-of-the-money Cheese call option with a strike price of $1.75 for a premium of 2 cents.
This means that he will implement the strategy at a net premium cost of 3 cents: the difference between the 5-cent premium he paid and the 2-cent premium he received. The net premium is deducted from the calculations to determine the ceiling and floor prices.
With this strategy he can establish a floor price of $1.52 per pound, which equals the put strike price of $1.55 minus the 3-cent net premium he paid. And he establishes a ceiling price of $1.72 per pound, which equals the call strike price of $1.75 minus the 3-cent net premium he paid.
The cheese exporter now has a selling price range for his cheese. This means that no matter what happens in the Cheese futures market during the life of the option, his net selling price will be no lower than $1.52 per pound and no higher than $1.72 per pound.
For instance, if the Cheese futures price drops to $1.45, his net selling price will be $1.52 per pound: the futures price of $1.45 plus 10 cents, which is the difference between the put strike price and the futures price, minus the 3-cent net premium he paid.
On the other hand, if the Cheese futures price goes up to $1.85, his net selling price will be $1.72 per pound: the futures price of $1.85 minus 10 cents, which is the difference between the futures price and the call strike price, minus the 3-cent net premium he paid.
The selling price range, 20 cents, is the difference between the two strike prices. The cheese exporter will choose his price range based on the risk tolerance of his business.
It is important to keep in mind that, as the seller of the call option side of the strategy, he will be required to post a performance bond upfront at the time that he sells them.
Now that the cheese exporter knows the minimum and maximum prices he will receive for his cheese, he can plan and make decisions for his 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 falling prices to have peace of mind knowing that they have taken steps to manage the risk involved in selling these commodities.