Options Contracts Slide Show Courtesy of: Cooperative Extension – Ag and Natural Resources Farm and Risk Management Team Last Update: May 1, 2009

What Are Options Contacts? A PUT option is the right – but not the obligation – to SELL a futures contract at the strike price A CALL option is the right – but not the obligation – to BUY a futures contract at the strike price The price of the option is called the PREMIUM Premiums depend on: Strike price relative to futures price Time to expiration Futures price volatility Options are seldom exercised – there is no advantage to exercising the class III options because they are cash settled against the announced USDA class III price

Options Terminology) Premium: The “price” of a put option. Strike Price (Sometimes called Exercise Price): The price of the underlying futures contract you would receive if you exercised your option, There will be trading in options with several different strike prices for the same contract month. Basis: The difference between the milk check price and the announced Class III price Will be determined by local markets

Put Options – Buyers and Sellers Put buyer Pays premium Has the right to exercise into a SHORT futures position Pays no performance bond (margin) Put seller Collects premium Has the obligation to accept a LONG futures position if assigned Insures put buyer by depositing and maintaining margin

How Do Put Options Provide a Price Floor? Suppose You need a $14.00 milk price to keep your banker happy The October Class III is trading at $13.83. If that price holds: $13.83 + $1.17 Basis = $15.00 = Happy banker But suppose the October Class III price is announced at $12.50: $12.50 + $1.17 Basis = $13.67 = Unhappy banker You’re fairly confident that the Class III price will be at or above $13.83 when it’s announced, but you don’t want to take the chance of it falling below $12.83 (= $14.00 – $1.17 Basis)

How Do Put Options Provide a Price Floor (2)? Solution: Buy an October Class III $13.75 Put at $.83. Minimum Price: $13.75 Put strike price + 1.17 Basis - .83 Premium - .05 Commission = 14.04 Net minimum price Announced Option Option Net Oct. Class III Basis Gain Premium Comm. Price $12.00 +1.17 +1.75 -.83 -.05 14.04 $13.50 +1.17 + .25 -.83 -.05 14.04 $15.00 +1.17 -0- -.83 -.05 15.29

How Do Put Options Provide a Price Floor (3)? BUT WAIT – Wouldn’t you be better off selling the Oct Class III futures at $13.83????? Fixed Price: $13.83 October Class III + 1.17 Basis - .05 Commission = 14.95 Net fixed price Announced Futures Net Oct. Class III Basis Gain/loss Comm. Price $12.00 +1.17 +1.83 -.05 14.95 $13.50 +1.17 + .33 -.05 14.95 $15.00 +1.17 - 1.17 -.05 14.95 Options allow you to benefit from rising prices, but at a cost (the premium). SO: Whether you hedge or buy a put depends on your expectations about future prices. QUESTION: What is “breakeven” Class III price (at which futures hedge and put purchase yield same net price)?????

Pros and Cons of Buying Put Options Advantages: Provide price floor in volatile markets Give flexibility in the amount of price protection desired – can select your “deductible” In contrast to futures, can benefit from upside price movements No margin requirement Disadvantages Premiums are very high in unstable markets Less price protection than futures in a falling market

CME Class III Milk Options Contract Specifications Underlying Contract One Class III fluid milk futures contract Price Quote Cents/Pound (= $/Cwt) Min. Price Fluctuation .0001 cents/Lb. ($20/Contract) No daily price limit Strike Prices Intervals of 25 Cents Contract Months All Calendar Months Last Trading Day Business day prior to release date of Class III price. The Class III price is released on the Friday on or before the 5th of the month Settlement Cash-settled to the announced monthly USDA Class III price or can be exercised any time up to and including the last trading day The CME also trades a “midi” option, which is ½ the volume of the standard option..

Put Option Examples (1) Date/Action Feb. 2 Buy 1 CME Sep 13.75 put option Premium is 0.36. Expected basis is 1.20. Broker commission (round turn) is .05. Expected MINIMUM September farm milk price is $14.54 ($12.75 strike price + $1.20 Basis – $0.36 premium - .$05 commission) Case I: Price falls by September; No basis change Oct. 1 - Class III price announcement is 13.00 Sell milk to plant @ 14.20 (Class III + 1.20 Basis) +/- Put Option gain/loss + .39 (.75 gain - .36 premium) Commission - .05 = Net milk price 14.54 Case II: Price rises by September; No basis change Oct. 1 - Class III price announcement is 14.00 Sell milk to plant @ 15.20 (Class III + 1.20 Basis) +/- Put Option gain/loss - .36 (expires worthless - .36 premium) Commission - . 05 = Net milk price 14.79

Put Option Examples (2) Date/Action Sep 22 Buy 1 CME Jan 12.00 put option Premium is 0..50. Expected basis is 1.70. Broker commission (round turn) is .05. Expected MINIMUM September farm milk price is $13.15 ($12.00 strike price + $1.70 Basis –$0.50 premium - .$05 commission) Case I: Price falls by January; Basis is 1.90 at time of sale Feb 1 - Class III price announcement is 11.00 Sell milk to plant @ 12.90 (Class III + 1.90 Basis) +/- Put Option gain/loss + .50 (1.00 gain - .50 premium) Commission - .05 = Net milk price 13.35 (exceeds price minimum by the basis increase [.20]) Case II: Price rises by January; Basis is 1.20 at time of sale Feb 1 - Class III price announcement is 13.00 Sell milk to plant @ 14.20 (Class III + 1.20 Basis) +/- Put Option gain/loss - 50 (expires worthless - .50 premium) Commission - .05 = Net milk price 13.65 (exceeds price minimum, but less than price expectation by the basis decrease

Imperfect Hedges Q: What is your net price? Production uncertainties - Can’t perfectly predict production Lumpy contracts - Can’t purchase options (or sell futures) exactly equal to volume of production Expect to sell 225,000 pounds of milk in Sep. Buy 1 CME Sep 13.00 put @ $.40. Sep futures is $13.75. Basis is + $1.50 and Commission is $.05. Minimum price is $13.00 (strike) + 1.50 (basis) - .40 (premium) - .05 (commission) = $14.05. Announced Sep Class III @ settlement is $12.00. September milk sales are 250,000 pounds. Basis is $1.50 Q: What is your net price?

Imperfect Hedges (2) Sell milk to plant @ $13.50 (12.00 Class III + 1.50 Basis) +/- Options gain/loss + .60 (1.00 gain - .40 premium Commission - .05 Net price 14.05 Floor price ON HEDGED MILK BUT: Hedged only 200,000 pounds, so 50,000 pounds unhedged Gross milk revenue $33,750 (2,500 CWT * $13.50) - Total Premium 800 (2,000 CWT * $ .40) + Option Gain 2,000 (2,000 CWT * $ 1.00) - Total Commission 100 (2,000 CWT * $ .05) = Net Revenue $34,850 Divided by 2,500 CWT = $13.94

Hedge, Buy Puts, or Do Nothing? It all Depends….. Date/Action Hedge Buy Puts Do Nothing Feb 23 Sell Sep Class III @ 13.39. Expected September farm milk price is $14.54 Buy Sep 13.25 Put @ 0.55. Expected MINIMUM September milk price is $13.85 Take a nap. Sep. 1: Class III = 12.00 Milk Price Fut./Opt. Gain/Loss Comm. Net Milk Price 13.20 + 1.39 .05 14.54 + .70 13.85 0.00 Sep. 1: Class III = 13.39 14.59 + 0.00 - 0.55 13.99 Sep. 1: Class III = 15.00 16.20 - 1.61 15.60 Basis = + $1.20; Commission (futures or options) = $0.05)

Hedge, Buy Puts, or Do Nothing? It All Depends….. If you know prices are going to fall relative to current levels, then hedging (sell futures contract) is the optimal choice – even if the futures price doesn’t meet your price goal If you know prices are going to rise, then do nothing If the odds are 50-50, then buying puts will provide down-side price protection but leave the opportunity for up-side gains. But remember that when you buy puts, there was always a better choice after the fact. Problem: Ya Never Know! So take action to meet your financial and personal goals, not to beat the market