For some time now, dairy producers have had the opportunity to shield themselves from price risk by entering into forward-price contracts with dairy plants. These arrangements do not require producers to post margin money or pay premiums, and they give producers a guaranteed price for milk to be delivered in the future.
The one negative of forward contracts is that they do not allow producers to capture any gains if milk prices rise. Many dairy producers who entered into forward contracts during the past few years have been frustrated when milk prices rose after they had contracted their milk. And producers who have already contracted some of their 2003 production may assume they have no way to gain a higher price if milk prices rise. However, this assumption is false.
Producers who forward contract milk with their co-op can still use options to capture some of the upward movement in milk prices.
How options to work
Options are traded on the Chicago Mercantile Exchange. And in order to capture upside market potential, you would use a call option. This financial tool gives you the right to purchase a milk futures contract at a specified price, known as the strike price.
The payoff from owning a call option is that it locks in the purchase price of milk futures contracts. Then, if the milk price does rise, you buy a milk futures contract at the strike price you selected, and then sell the milk futures contract at the prevailing market price and pocket the difference.
However, when milk prices drop, it is not possible to capture a financial gain from this strategy. So, in this case, you would merely let the call option expire.
In order to get a call option for milk, you must pay a premium. The amount of the premium varies inversely with the strike price you select. Thus, the premiums on call options are relatively high when you select a low strike price — one close to the actual market price at the time — and lower for higher strike prices.
The following example illustrates how you can use a call option to gain upside price opportunities on milk that you have forward contracted.
In May, a producer forward contracts his November milk production for $11.45 per hundredweight. However, the producer believes prices will trend upward. To capture that upside potential, he purchases a call option for November milk. He selects a strike price of $11.50. The premium for that call option is 82 cents. That makes the producer’s price floor $10.63 ($11.45 - 82 cents).
The floor price is the absolute minimum the producer would receive for his November milk. However, it is not necessarily the net price the producer will receive. If, as the producer expects, milk prices rise, the producer will exercise his call option and add that income to determine his net milk price. The table below shows the net price the producer would receive for milk if the November futures price rises to various levels.
Consider your options
This example shows how you can capture some of the upward price movements on milk even though you may have already forward contracted your production. This strategy does not allow you to achieve the top market price, but it allows you to lock in a price floor and gives you the opportunity to gain part of any price increase that may occur.
Producers who have forward contracted to get downside price protection can still use options to position themselves to capture some of the milk price increase expected to materialize later this year. Work with a broker to learn more about how to put call options to work for you.
Bruce Jones is a professor of agricultural economics and farm management specialist at the University of Wisconsin.