Managing Price Volatility
Buying U.S. Dairy Using CME Dairy Options
Assume you are a buyer in July 2015 and you are considering your purchase requirements for the start of the following year. You forecast that you will need to buy 100 metric tons (mt) of U.S. Non Fat Dry Milk (NFDM) in January 2016. The market price for NFDM has dropped significantly over the previous year and at the time you are making your decision the spot market is at its lowest level since 2009, trading at roughly $2,000/mt.
You want to secure the current low prices for your January 2016 purchases but the Futures market is higher in January 2016 where the sellers are looking for roughly $2,250/mt. Since you think the market will remain weak for the foreseeable future, you decide to purchase a Call option for your January requirement instead of locking in the Futures price.
A Call option is the right but not the obligation to buy a Futures contract at a pre-agreed upon price. If you buy a Call option you pay a premium for this right to buy a Futures contract at the strike price if the market is higher, but unlike with the Futures contract if the market is lower you are not obliged to buy at the higher strike price; meaning you can protect while benefiting from lower prices as well.
You decide to buy a Call option at $2,500/mt which means you have the right but not the obligation to buy Futures in January 2016 at $2,500/mt and for this right you have to pay a premium of $50/mt to get the protection (premium calculation is indication only and subject to change based on market conditions.)
If in January 2016 the market price (AMS) is $2,950/mt, you will have to pay close to this for your physical product but will exercise your option at $2,500 and gain $450 profit to compensate for this higher price (less the premium $50 you paid initially). The upside price risk is capped at $2,550/mt. If, however, in January 2016 the market price is $2,000/mt, you will choose not to exercise the option but simply source the physical product in the market at the lower market price, which is $2,000 plus $50 or $2,050/mt. There is no bottom to how low the price can fall, but you are still protected against a large price rise.