Cash being pulled out of safe.
November 11, 2016

Put Puts to Work

 |  By: Jim Dickrell

Dairy futures contracts can offer real and tangible risk protection, but they come with loathe-some margin calls and margin account requirements.That’s why options are preferred by many users. You buy the option, and you’re done.

To lower costs, some farmers will create a put/call fence. They buy a put to protect downside risk, and then sell a call at some higher level and apply the money to the put premium. That lowers the cost of the put, but also limits the upside potential if markets rise above the call strike price. Plus, this strategy may result in margin calls.

But there’s another way, a put spread, which will lower costs and reduce some of the downside risk. It’s a method Robin Schmahl, a hedge and marketing specialist with AgDairy, LLC, has been using with clients for years.

“The put option spread consists of the purchase of an at-the-money put option, and the sale of an out-of-the-money put option,” he explains. Typically, the out-of-the-money put is purchased at $1.25 to $1.50 below the at-the-money option.

“This establishes a floor, but limits downside price protection to the level of the sold put option,” he says. While perhaps not ideal, it lowers the cost of the transaction and provides some price protection. And if markets move lower, you always have the option of putting on another put spread.

Here’s how it works: Say you buy an at-the-money put at $15.50, and sell a put at $14.25. The price of the $15.50 put is 80¢/cwt and the price of the $14.25 put is 25¢/cwt, meaning you have 55¢/cwt invested in the strategy.

If the market drops to $14.25, you will be protected to that level and net 70¢/cwt after transaction costs. If the market drops below $14.25, you will have no further price protection. “But at least you’ve done something,” says Schmahl. Had you done nothing you would have lost the $1.25 (between $15.50 and $14.25) and whatever the final settlement price is.

If the market settles above $15.50, you would “lose” the 55¢/cwt invested in the strategy. But you have protected equity against a falling market. “The goal of marketing is not to make money, but to protect income and equity,” says Schmahl. “There is no greater risk to your business than human greed.”