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

2. 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

3. 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

4. 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

5. 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 $ If that price holds:
$ $1.17 Basis = $15.00 = Happy banker
But suppose the October Class III price is announced at $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)

6. How Do Put Options Provide a Price Floor (2)?
Solution: Buy an October Class III $13.75 Put at $.83.
Minimum Price: $ Put strike price
Basis
Premium
Commission
= Net minimum price
Announced Option Option Net
Oct. Class III Basis Gain Premium Comm. Price $ $ $

7. 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: $ October Class III
Basis
Commission
= Net fixed price
Announced Futures Net
Oct. Class III Basis Gain/loss Comm. Price $ $ $
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)?????

8. 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

9. 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..

10. Put Option Examples (1) Date/Action Feb. 2
Buy 1 CME Sep put option Premium is Expected basis is Broker commission (round turn) is Expected MINIMUM September farm milk price is $14.54 ($ 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 (Class III Basis)
+/- Put Option gain/loss (.75 gain premium)
Commission
= Net milk price
Case II: Price rises by September; No basis change
Oct. 1 - Class III price announcement is 14.00
Sell milk to (Class III Basis)
+/- Put Option gain/loss (expires worthless premium)
Commission
= Net milk price

11. Put Option Examples (2) Date/Action Sep 22
Buy 1 CME Jan put option Premium is Expected basis is Broker commission (round turn) is Expected MINIMUM September farm milk price is $13.15 ($ 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 (Class III Basis)
+/- Put Option gain/loss (1.00 gain premium)
Commission
= Net milk price (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 (Class III Basis)
+/- Put Option gain/loss (expires worthless premium)
Commission
= Net milk price (exceeds price minimum, but less than price expectation
by the basis decrease

12. 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 $.40. Sep futures is $ Basis is + $1.50 and Commission is $.05. Minimum price is $13.00 (strike) (basis) (premium) (commission) = $14.05.
Announced Sep Class settlement is $ September milk sales are 250,000 pounds. Basis is $1.50
Q: What is your net price?

13. Imperfect Hedges (2)
Sell milk to $13.50 (12.00 Class III Basis)
+/- Options gain/loss (1.00 gain premium
Commission
Net price 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 (2,000 CWT * $ )
+ Option Gain ,000 (2,000 CWT * $ 1.00)
- Total Commission (2,000 CWT * $ )
= Net Revenue $34,850
Divided by 2,500 CWT = $13.94

14. Hedge, Buy Puts, or Do Nothing? It all Depends…..
Date/Action
Hedge
Buy Puts
Do Nothing
Feb 23
Sell Sep Class Expected September farm milk price is $14.54
Buy Sep 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
13.85
0.00
Sep. 1: Class III = 13.39
14.59
+ 0.00
13.99
Sep. 1: Class III = 15.00
16.20
15.60
Basis = + $1.20; Commission (futures or options) = $0.05)

15. 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