Establishing a Floor Price by Buying Dairy Put Options

Establishing a Floor Price by Buying Dairy Put Options

There are many risk management strategies offering price protection for short hedgers in the dairy industry,  producers or sellers of dairy products. Dairy producers, manufacturers, exporters and food processors understand the impact a decline in prices could have on their business. It is important that they at least familiarize themselves with the various alternatives for mitigating this risk and protecting their bottom line.

Selling dairy futures contracts allows short hedgers to lock in a selling 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 short hedgers, who calculate the selling price that will allow their business to be profitable.

However, some short hedgers would like the ability to establish a minimum selling price, while still being able to take advantage of a potential increase in dairy prices.  That is where options come in, offering price protection plus flexibility.

This module will describe how dairy sellers can purchase put options to establish a minimum, or floor, selling price, while still maintaining the opportunity to sell at a higher price.  For the sake of simplicity, these examples will not consider the dairy basis or futures transaction costs.

Declining Prices

Assume that it is December and a cheese exporter is planning to sell a portion of his inventory of cheddar in early spring.  She is concerned that cheese prices may decline by the time he is ready to sell in April.  The current April Cheese futures price is $1.75 per pound. 

The exporter determined that receiving $1.70 per pound for cheese will allow her operations to break even, so she is attracted by the possibility of being able to sell at a higher price. 

Now, one alternative is to lock in the selling price of $1.75 with a short futures hedge, in other words, by selling April Cheese futures at $1.75. However, the exporter decides to use put options to establish a floor selling price, and retain the opportunity to potentially sell her cheese at a higher price. By purchasing the put option, she has the right—but not the obligation— to sell futures at the strike price of the option.

In December, an April at-the-money Cheese put option with a strike price of $1.75 costs 5 cents.  With this put option, she will establish a floor price of $1.70, which equals the put option strike price of $1.75, minus the 5-cent premium she paid for the option. If Cheese prices fall, this is the minimum price that she will receive.

For instance, suppose in April Cheese futures prices fall to $1.60 per pound. This is 15 cents lower than the exporter was anticipating back in December.

But since the put option gives the cheese exporter the right to sell Cheese futures at $1.75, even though the current futures price is $1.60, the put option has a value of at least 15 cents: the $1.75 strike price minus the futures price.

Deducting the 5-cent premium means a net gain of 10 cents on his put option hedge, giving her an effective net selling price of $1.70 per pound: the $1.60 futures price plus the gain on the put option. Again, no matter how low cheese prices fall, by the time she sells her cheese in April, the lowest price she will receive is $1.70.

Rising Prices

But suppose the April Cheese futures price rises above the $1.75 strike price? In this situation, the cheese exporter will still be able to participate in the upward price movement. 

For example, say April Cheese futures increase to $1.85 per pound.  Since the $1.85 futures price is higher than the $1.75 strike price of the put option, the exporter allows the option to expire, and sells her cheese in the cash market.

The most she will lose is the 5-cent premium he paid upfront. His net selling price will be $1.80, which is the futures price of $1.85, minus the 5-cent premium.

Now that the exporter has established a minimum selling price of 1.70 in a falling market, the net selling price of $1.70 was lower compared to the $1.75 she would have locked in with the short futures hedge. The difference, essentially, being the option premium. 

The cheese exporter was quite willing to pay the premium, however, because it allowed her to secure protection from declining prices and, unlike the short futures hedge,  she can still get a higher price for her cheese in a rising market: $1.80 per pound versus $1.75 with a futures hedge.

She will receive less for his cheese in this scenario than the $1.85 had she not hedged at all—the difference, again, being the option premium. But, knowing that the price could just as easily have declined, she was willing to pay this cost to ensure a minimum selling price for her cheese. 

Keep in mind that the cheese exporter also has the possibility of selling her put option for any time value that it may still hold. Whatever she receives from selling the option would increase her net selling price even more.

Conclusion

To summarize the benefits of buying put options for the short hedger:

• She knows the cost of the option and the maximum loss up front: the option premium
• She can establish a floor price for his sales
• She still can take advantage of higher prices

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 of knowing that they have taken steps to manage the risk involved in producing and selling dairy and dairy products for their business.